What it means
A bond earns interest every day, but it only pays that interest on set dates. Just before a payment, the bond's price includes the interest that has built up but has not yet been paid.
An investor who sells at that point receives the accrued interest as part of the sale price. In a classic wash, the investor sells the bond with the interest included and buys back an equivalent bond just after the payment date.
The investor holds a bond in the same issuer again, but the interest income has been dressed up as a higher sale price. If capital gains were taxed more lightly than income, the investor saved tax.
Tax authorities saw this pattern long ago and responded. In the United Kingdom, for example, the accrued income scheme was created so that interest built up at the time of sale is taxed as income.
Other countries use rules that treat the accrued part of the sale price as interest. The technique matters in modern finance mostly as a lesson in how anti-avoidance rules work.
Tax law looks at the real economic substance of a deal, not just the paperwork. A trade made mainly for a tax advantage can be recharacterised by the authorities.
Related ideas include wash sales in share trading, where a loss is claimed on a sale and the same security is bought back almost immediately. Many tax systems deny the loss in that case.
Managers who deal with investment portfolios should be aware that timing trades around payment dates can attract scrutiny.
In practice
Real-world examples.
Example
A private investor holds a government bond and sells it two days before a coupon date, planning to buy it back the day after. Her accountant warns that the accrued interest in the sale price will be taxed as income anyway. She drops the plan and keeps holding the bond through the payment date instead.
Example
A family office reviews its trading rules and bans any sale-and-repurchase of the same bond within a short window around interest dates. The compliance officer wants to avoid trades that look driven only by tax. The rule is written into the investment policy and reviewed each year by the trustees.
Example
A tax adviser at an accounting firm trains junior staff on anti-avoidance rules. She uses bond washing as a case where the legal form of a trade differs from its economic substance, and the authorities respond by taxing the substance. The class then discusses how to explain such rules to non-specialist clients.
Formula
Calculation
Accrued interest = Face value x Coupon rate x Days since last payment / 365
Suppose an investor holds a bond with a face value of $100,000 and a 6% annual coupon. She sells it 90 days after the last interest payment. The annual interest is 100,000 x 0.06 = $6,000.
Accrued interest = 6,000 x 90 / 365 = $1,479.45. Under accrued income rules, this amount is taxed as interest, even though it is received inside the sale price.Case study
Seen in the real world.
Wexford Family Investments is a fictional investment vehicle holding a large portfolio of corporate bonds. A new portfolio manager suggests selling several bonds just before each coupon date and repurchasing similar bonds afterwards, to book gains instead of interest. He expects the tax charge to fall.
The company's tax adviser, who has seen similar proposals before, reviews the idea and points out that accrued income rules would tax the interest portion as income whatever the structure. She also warns that the trades might be challenged as artificial. This illustrative case ends with the proposal being dropped, and the firm saving transaction costs it would have paid for no benefit.
The manager's idea was not wicked, only incomplete, because he had looked at the trade in isolation. The adviser's review turned a risky tax shortcut into a short policy note that now sits in the firm's investment procedures. New staff read it during onboarding.
Watch out
Common mistakes.
- Thinking a sale before a coupon date turns interest into a tax-free gain. Most tax systems tax the accrued part of the price as income.
- Assuming that a technique that was once allowed is still safe. Anti-avoidance rules change, and old schemes are often closed.
- Confusing bond washing with a wash sale in shares. They share a similar idea of selling and rebuying, but the tax rules and purposes differ.
Questions
People also ask.
Is bond washing illegal?
It is better described as avoidance that the rules have largely closed off, and aggressive versions can be challenged or penalised.
Why does the price include accrued interest?
Because the seller has earned the interest for the days held, and the buyer compensates the seller for it.
Does this affect ordinary investors?
Only when they trade around coupon dates, and in that case the accrued interest is normally handled automatically by the rules.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related