Accrued interest is the amount of interest that has been earned on a security, such as a bond, between interest payments. Most municipal bonds pay interest every six months; in the interim, however, the bond gradually accrues interest until one payment is made at the six-month mark.
When a bond or security is purchased between interest payment dates, the price of the bond includes the accrued interest. The buyer pays the seller the accrued interest as, otherwise, the seller will not receive any of the interest earned while holding the security for a partial period.
For convenience, accrued interest is usually calculated based on a 360-day year, which assumes each month has 30 days.
For example, a 4 percent, $5,000 bond may pay $100 in interest each January 1 and July 1. If a buyer purchases the bond on May 1, four months of interest, or $67, has accrued. In other words, the seller has already earned $67 by holding the bond until May. When the buyer purchases the bond, the money paid to the seller will include the $67 in accrued interest earned by the seller.
The entirety of the $100 interest payment on July 1 will go to the buyer holding the bond as of that date. Thus, by paying the $67 of accrued interest to the seller when purchasing the bond, the buyer effectively earns $37 in interest in that period, or the equivalent of holding the bond for two months from May 1 to July 1.