What it means
Bonds pay interest at fixed intervals, usually every six months, but they trade every day. If a bond is sold two months into a coupon period, the seller has earned two months of interest that will nevertheless be paid to whoever holds the bond on the payment date.
The dirty price solves this by making the buyer reimburse the seller for that earned but unpaid interest at settlement. Markets quote clean prices for a practical reason: accrued interest rises in a predictable sawtooth pattern and then drops to zero on each coupon date, which would make quoted prices look volatile even when nothing had changed.
Stripping it out produces a quoted price that moves only with interest rates and credit quality, which is what traders actually want to compare. The calculation is straightforward.
Accrued interest equals the coupon payment for the period multiplied by the fraction of the period that has elapsed, using whatever day count convention applies to that bond, and the dirty price is simply the clean price plus that amount. The nuance that catches people out is the day count convention.
Corporate bonds in many markets use a 30/360 basis that treats every month as thirty days, while government bonds commonly use actual days over the actual period, and the two produce slightly different accrued figures for the same bond and settlement date. For a finance team, the dirty price is the number that matters for cash planning and for accounting entries, because it is what leaves the bank account.
The accrued interest portion is normally recorded separately from the investment itself, so that when the coupon arrives only the genuinely earned part flows through income.
In practice
Real-world examples.
Example
A corporate treasurer investing surplus cash in a two-year bond budgets $500,000 for the purchase, then finds the settlement instruction is for $506,200 because of accrued interest. The extra amount is not a cost, but it does have to be funded on the day.
Example
A fund accountant reconciling a portfolio finds a valuation discrepancy against the custodian. The fund is valuing at clean prices and the custodian is reporting dirty prices, and once accrued interest is added to the fund's figures the two agree exactly.
Example
A private investor comparing two similar bonds sees quoted prices of 101.20 and 101.60 and assumes the second is more expensive. In fact the second bond is nine days from its coupon date with almost no accrued interest, while the first is five months into its period, so on a dirty price basis the first costs considerably more.
Formula
Calculation
Accrued interest = coupon payment per period x (days since last coupon / days in coupon period)
Dirty price = clean price + accrued interest
An investor buys $100,000 face value of a corporate bond paying a 6% annual coupon in two equal semi-annual instalments. Each coupon payment is therefore $100,000 x 6% / 2 = $3,000.
The bond is quoted at a clean price of 98.50, meaning 98.50% of face value. In dollars that is $100,000 x 0.9850 = $98,500.
Settlement falls 60 days into a 180-day coupon period on a 30/360 basis. Accrued interest is $3,000 x (60 / 180) = $3,000 x 0.3333 = $1,000.
The dirty price is $98,500 + $1,000 = $99,500, and that is the amount the buyer wires on settlement day. When the next coupon of $3,000 arrives 120 days later, $1,000 of it simply repays what the buyer advanced and only $2,000 represents interest the buyer genuinely earned.Case study
Seen in the real world.
Ashgrove Endowment Trust is a fictional institution used here as an illustrative example only. Its investment committee approved a $12 million allocation to investment grade corporate bonds and instructed the treasury team to fund exactly that amount from the operating account on settlement date.
The purchases settled at dirty prices, and because most of the bonds were four to five months into their coupon periods, the accrued interest component came to just over $190,000 more than the clean value of the trades. The operating account went overdrawn for two days and the trust paid an unnecessary facility fee.
In this illustrative case nothing was lost economically, since the accrued interest was returned in full at the next coupon dates. The process fix was simply to require the settlement schedule, priced on a dirty basis, to be produced before the funding instruction rather than after it.
Watch out
Common mistakes.
- Budgeting a bond purchase using the quoted price. The cash required is the dirty price, and on a large trade the accrued interest can be a meaningful funding requirement.
- Treating accrued interest paid at purchase as investment income. It is a reimbursement to the seller and is recovered from the first coupon, so only the portion earned after purchase is genuine income.
- Applying the same day count convention to every bond. Corporate and government issues frequently differ, and using the wrong basis produces a settlement figure that will not match the counterparty's.
Questions
People also ask.
Why do markets quote clean prices at all?
Because accrued interest rises and resets on a fixed schedule, and removing it lets the quoted price reflect only changes in interest rates and credit quality.
Does the dirty price affect the yield to maturity?
No, yield is calculated from the full cash flows and the dirty price paid, so it is unaffected by the quoting convention itself.
What happens on the coupon payment date?
Accrued interest resets to zero, so on that day the dirty price and the clean price of the bond are the same.
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%