When an investor purchases a bond in the secondary market, the cash amount required at settlement almost always differs from the price displayed on the broker’s screen. That difference is accrued interest, and understanding it separates the clean price from the dirty price.
The clean price is the quoted price of a bond excluding any interest accumulated since the last coupon payment. The dirty price—also called the invoice price or settlement price—is the total cash amount the buyer pays the seller, equal to the clean price plus accrued interest. On ECMSource, we demystify fixed income plumbing so investors can navigate secondary markets with clarity.
Key Takeaways
- Clean Price vs. Dirty Price: Financial media and brokerage screens quote the clean price (net of interest) so market price movements reflect pure yield changes. The dirty price is the actual settlement cash delivered.
- Accrued Interest Mechanics: The buyer compensates the seller for the exact number of days the seller held the bond during the current coupon period. On the next coupon date, the buyer collects the full coupon, recouping that advance.
- Day-Count Standards: U.S. Treasury notes and bonds use the Actual/Actual convention, whereas corporate and municipal bonds use the 30/360 convention.
- IRS Tax Treatment: Under IRS Publication 550, sellers report accrued interest received as ordinary interest income, while buyers treat accrued interest paid as a return of capital that reduces their taxable interest.
The Core Concept: Clean vs. Dirty Price
Most fixed income securities pay interest semiannually on fixed calendar dates. For instance, TreasuryDirect explains that “Notes pay a fixed rate of interest every six months until they mature. You can hold a note until it matures or sell it before it matures.”
Because secondary market transactions take place on arbitrary business days between these six-month milestones, the bond has earned interest that the issuer has not yet disbursed. Bond market convention solves this allocation problem through accrued interest:
Dirty Price (Invoice Price) = Clean Price + Accrued Interest
Why do quotes use the clean price? If bond dealers quoted the dirty price, an investor watching a terminal would see the bond’s quote steadily rise every day purely due to the passage of time, only to drop abruptly by the coupon amount on the coupon date. By quoting the clean price, price fluctuations reflect macroeconomic forces—such as changes in benchmark interest rates, duration and convexity, or credit spreads—rather than calendar drift.
Day-Count Conventions: Actual/Actual vs. 30/360
To compute accrued interest accurately, market participants determine the fraction of the semiannual coupon period that has elapsed between the last coupon payment date and the trade settlement date (which operates on a T+1 basis in U.S. markets). The formula is:
Accrued Interest = Semiannual Coupon × (Days Elapsed / Days in Coupon Period)
Two primary day-count conventions govern how days are counted:
- Actual/Actual (in period): Used for U.S. Treasury notes and bonds. The exact number of calendar days elapsed is divided by the actual number of calendar days in the specific semiannual period (typically 181 to 184 days).
- 30/360 (Bond Basis): Standard for U.S. corporate bonds and municipal debt. Every calendar month is assumed to have 30 days, and every year is assumed to have 360 days (180 days per half-year).
Worked Example: U.S. Treasury Note Settlement
Let us walk through a practical calculation with realistic numbers. Consider an investor purchasing a U.S. Treasury note with a $1,000 par value and a 4.00% annual coupon ($40.00 per year, or $20.00 semiannually), payable on May 15 and November 15.
Suppose the trade settles on August 15, exactly halfway through the coupon cycle, and the quoted clean price is 99.00% of par ($990.00):
- Days in Coupon Period (May 15 to Nov 15): May has 16 remaining days (31 – 15), June has 30, July has 31, August has 31, September has 30, October has 31, and November has 15. Total = 184 days.
- Days Elapsed (May 15 to Aug 15): 16 days in May + 30 days in June + 31 days in July + 15 days in August = 92 days.
- Accrued Interest: $20.00 × (92 / 184) = $10.00.
- Dirty (Invoice) Price: $990.00 clean price + $10.00 accrued interest = $1,000.00.
At settlement on August 15, the buyer delivers $1,000.00 in cash to the seller. Three months later, on November 15, the issuer pays the full $20.00 semiannual coupon directly to the buyer of record. The buyer receives $20.00, which exactly reimburses the $10.00 accrued interest advanced to the seller, while providing the buyer with the $10.00 earned for holding the bond from August 15 to November 15.
| Settlement Date | Days Elapsed | Clean Price Quote | Accrued Interest | Dirty (Cash) Price |
|---|---|---|---|---|
| May 15 (Coupon Date) | 0 / 184 | $990.00 | $0.00 | $990.00 |
| June 30 | 46 / 184 | $990.00 | $5.00 | $995.00 |
| August 15 (Midpoint) | 92 / 184 | $990.00 | $10.00 | $1,000.00 |
| September 30 | 138 / 184 | $990.00 | $15.00 | $1,005.00 |
| November 14 (Eve of Coupon) | 183 / 184 | $990.00 | $19.89 | $1,009.89 |
| November 15 (New Cycle) | 0 / 181 | $990.00 | $0.00 | $990.00 |
The Sawtooth Pattern of Invoice Prices
The relationship between clean and dirty prices creates what fixed income analysts call the sawtooth pattern. While the clean price remains stable when market interest rates are unchanged, the dirty price climbs linearly throughout the six-month coupon period as accrued interest accumulates. On the exact moment the coupon is distributed, the accrued interest drops back to zero, causing the dirty price to drop sharply by the full coupon value.
Special Cases: Trading Flat and Negative Accrued Interest
While the clean-to-dirty adjustment applies to standard performing debt, investors should be aware of critical exceptions in capital markets:
1. Bonds Trading “Flat”
When an issuer enters bankruptcy, defaults on a debt payment, or experiences severe restructuring distress, secondary trading shifts to trading flat. A bond that trades flat settles strictly at its clean price without any accrued interest addition. Because the issuer is unlikely to make timely coupon distributions, the buyer is not expected to advance unearned funds to the seller.
Similarly, income bonds and zero-coupon instruments—such as Treasury STRIPS or commercial paper—always trade flat because they do not make periodic coupon disbursements.
2. The “Buying a Coupon” Fallacy
Novice investors sometimes rush to purchase a bond a few days before its coupon date, thinking they will receive an immediate cash windfall. In reality, accrued interest eliminates this arbitrage: the buyer must advance nearly the entire coupon amount to the seller in the dirty price on settlement day. When the coupon arrives days later, it merely refunds the capital the buyer paid out at settlement.
IRS Tax Treatment: How Accrued Interest Is Reported
The tax treatment of accrued interest is strictly regulated to prevent double taxation or misallocation of ordinary income. IRS Publication 550 provides clear instructions for both parties involved in a secondary transaction:
Rules for the Seller
According to IRS Publication 550, “If you sell a bond between interest payment dates, part of the price represents interest accrued to the date of sale. You must report that part of the sales price as interest income for the year of sale.” Even though the payment is received from a secondary buyer rather than the bond issuer, the accrued interest portion is taxed as ordinary interest income, not capital gains.
Rules for the Buyer
For the purchaser, IRS Publication 550 specifies: “If you buy a bond between interest payment dates, part of the purchase price represents interest accrued before the date of purchase. When that interest is paid to you, treat it as a return of your capital investment, rather than interest income, by reducing your basis in the bond.”
When the full coupon is subsequently paid, the issuer reports the entire amount on Form 1099-INT. On Schedule B of Form 1040, the taxpayer enters the full interest amount reported on Form 1099-INT, and then enters a separate subtraction line labeled “Accrued Interest” to subtract the accrued interest paid to the seller, ensuring tax is paid only on interest earned during the holding period.
For additional perspective on comparing after-tax yields across different fixed income asset classes, explore our guide on tax-equivalent yield and our breakdown of Treasury bills discount rate vs. investment yield.
Sources & Further Reading
- TreasuryDirect: Treasury Notes Overview and Characteristics — U.S. Department of the Treasury.
- IRS Publication 550: Investment Income and Expenses (Bonds Sold Between Interest Dates) — Internal Revenue Service.
Disclosure: This article is for informational purposes only and is not investment advice.