Tuesday, May 21, 2013

Lisa Pallavi Barbora
November 16, 2012

# Understanding the nuances of clean, dirty bond price

Bond pricing is not a simple concept and sometimes it can confuse even experts. But understanding nuances of bond pricing is important as it determines the final yield you will earn on a transaction. One such matter is the price a bond is quoted at. Exchanges don't always have a uniform way of quoting bonds. Globally there are two ways - clean price and dirty price.

In Europe, the convention is to use the dirty price for trades and in the US, the clean price is preferred.

In India, depending on the exchange, you may see a dirty or a clean price.

Coupon and yield
To understand what the above means, let's first clarify that these terms are relevant for coupon paying bonds. A coupon is the annual interest payment offered by the issuer and is expressed as a percentage of the face value of a bond. It can be paid at any frequency set by the issuer; typically annual and semi-annual is what we find.

For example, a 10% XYZ Ltd non-convertible debenture with a face value of R1,000 is a bond which will pay R100 as interest to the holder every year.

Yield on the other hand is what you earn on a bond if you are buying from the secondary market. In the secondary market, a bond may not quote at a price equal to its face value.

So effectively for the above example, if the market price is R900, you are buying a bond worth R1,000 at a cheaper price and your yield is basically calculated by dividing the coupon rate with the market price and multiplying it with the face value. In this case, the current yield will be 11.1%.

Dirty price
The price of a bond is calculated by discounting all future cash flows. The concept of "dirty" price is relevant for bond prices in the secondary market as they are not always traded on the coupon payment date and hence the seller needs to be compensated for the number of days he/she has held the bond in between coupon payments. For example, let's consider a bond pays interest semi-annually and the payment dates are June 30 and December 31; if it gets sold on, say, March 21, then the seller would have forgone the coupon payment due on June 30. The "dirty" price of the bond includes the interest due but not paid up to March 31. So basically, in the secondary market, it is the bond price that reflects the present value of future cash flows and includes the accrued interest (since it is not paid out yet) for the number of days the seller has the bond before the coupon payment date.

Clean price
This is the price that doesn't include any accrued interest.

Immediately after any coupon payment date, clean price or bond is equal to the dirty price.