Posted in Finance, Accounting and Economics Terms, Total Reads: 392
Definition: Flat Bond
Flat bond is a bond which is traded or sold without accrued interest. Clean price or flat bond refers to the price of the bond excluding any interest that has been accrued since the most recent coupon payment whereas Dirty price refers to the price of a bond including the interest that has been accrued since the most recent coupon payment.
There are 3 reasons why bonds may sold at clean price
• No interest is due on the bond
• Interest is due but the bond issuer has defaulted
• Bond’s interest payment date is same as its settlement date therefore there is no additional accrued interest beyond the amount that is already paid out
For e.g. Income bonds are normally sold as flat bonds.
Let us take the example of a 20 year bond with 3% interest rate and observe its market value during its first four years. We can see that the shark tooth pattern rises and drops every six months, reflecting the bond’s accrued interest that is paid out in coupon semi-annually. Also there is a gradual decrease in market value followed by a gradual increase indicating a better credit quality of the issuer.
If the two processes i.e. the change in market value and accrued interest are separated we get the clean or flat price of the bond as shown below.
Clean Price or Flat bond = Dirty Price – Accrued Interest
The bond’s acrrued interest is shown below
Accrued interest = Coupon * (days between last coupon payment and settlement date/ coupon period)
Settlement date is the date on which the traded bond is exchanged and is paid for.