Key Takeaways
- Includes bond price plus accrued interest.
- Represents actual cash paid at settlement.
- Changes daily as interest accumulates.
- Also called full or invoice price.
What is Dirty Price?
The dirty price is the total amount paid for a bond at settlement, combining the bond's market value and any accrued interest since the last coupon payment. This full price reflects the actual cash exchanged in a bond transaction, unlike the clean price which excludes accrued interest.
Accrued interest is calculated based on the bond's coupon payment and the accrual period, which depends on the day count convention used. The dirty price ensures the seller is compensated fairly for interest earned up to the settlement date.
Key Characteristics
Understanding the dirty price involves recognizing its main features:
- Includes Accrued Interest: The dirty price equals the clean price plus accrued interest, reflecting the true cost to the buyer.
- Varies Daily: Unlike the clean price, the dirty price changes daily as interest accumulates until the next coupon payment.
- Settlement Amount: It represents the actual payment made during bond settlement, not just a quoted market value.
- Terminology: Also known as full price, gross price, or invoice price in bond markets.
- Influenced by Face Value: Coupon payments and accrued interest calculations are based on the bond’s face value.
How It Works
When you purchase a bond between coupon dates, the dirty price accounts for interest earned but not yet paid to the seller. The accrued interest portion is computed using the coupon rate and the fraction of the coupon period that has elapsed, determined by the day count method.
The dirty price fluctuates daily because accrued interest grows until the next coupon payment resets it to zero. This mechanism ensures the seller receives fair compensation for holding the bond during the accrual period, which is especially important for bonds that are callable or have irregular payment schedules.
Examples and Use Cases
Here are practical examples illustrating the dirty price concept:
- Airlines: Investors buying bonds from companies like Delta or American Airlines pay the dirty price, covering both the bond’s value and accrued interest since the last coupon date.
- Bond ETFs: When investing in fixed-income funds such as those featured in best bond ETFs, understanding dirty price helps clarify NAV calculations and fund valuation.
- Index Funds: Fixed-income holdings in low-cost funds from guides like best low cost index funds also reflect dirty prices in their bond valuations, affecting overall returns.
Important Considerations
When dealing with dirty prices, remember that they provide a more accurate reflection of the cash flow involved in bond transactions but can introduce daily price volatility due to interest accrual. This is why many markets prefer quoting clean prices for simplicity and comparison.
Additionally, zero-coupon bonds have identical clean and dirty prices since they do not pay periodic interest. Knowing when to use dirty versus clean price is crucial for accurate portfolio valuation and trading decisions.
Final Words
The dirty price shows the full cash cost of buying a bond, including accrued interest owed to the seller. To make informed decisions, compare dirty prices across bonds and factor in timing relative to coupon payments for accurate cost assessments.
Frequently Asked Questions
Dirty price is the total amount paid for a bond at settlement, which includes the bond's market value plus any accrued interest since the last coupon payment. It reflects the actual cash exchanged between buyer and seller.
Dirty price is calculated by adding the clean price of the bond to the accrued interest. The accrued interest is determined by multiplying the coupon payment by the fraction of the coupon period that has elapsed.
The clean price excludes accrued interest and is used mainly for market comparison, while the dirty price includes accrued interest and represents the actual amount paid at settlement. Clean prices are more common in the U.S., whereas dirty prices are preferred in Europe.
The dirty price changes daily because accrued interest accumulates each day between coupon payments, increasing the total amount the buyer must pay. This continues until the next coupon payment resets the accrued interest to zero.
Dirty price and clean price are the same immediately after a coupon payment since the accrued interest resets to zero at that point, meaning no accumulated interest is added to the bond's market value.
Dirty price is important because it ensures the seller receives fair compensation for the interest earned during their holding period. It represents the true cash amount exchanged during bond settlement.
Dirty price is also known as full price, gross price, or invoice price, all referring to the bond price including accrued interest at settlement.
