For a range of investments, such as bonds, notes, loans, mortgages, medium-term notes, swaps, and forward rate agreements, a day count convention governs how interest accumulates over time (FRAs). This establishes the number of days that must pass between two coupon payments in order to calculate both the amount transferred on payment dates and the interest that has accrued during those intervals.
When discounting a cash flow to its present value, the day count is also employed to quantify time intervals. The seller is entitled to a portion of the coupon amount when they sell a security like a bond between interest payment periods.
Types Of Day-Count Conventions
1. Actual Method
The accrual period or coupon term should be counted using the real method's actual number of days.
According to the Actual/Actual technique, which counts the actual number of days in each month and year, the accrual period must be counted from the effective date to the termination date day by day, and the coupon period must be calculated from one specific coupon day to the next. U.S. Treasury bonds often employ the Actual/Actual approach.
2. 30/360 Method
The 30/360 approach does not need counting real days, unlike the Actual/Actual method. The denominator of an accrual factor (days in the year), which is determined by the 30/360 basis, is 360, which is made up of 12 30-day months.
The date will be changed to the 30th of that month if the start day or end day of an accrual period falls on that day. Corporate bonds typically have a basis of 30/360.
How Does it Work?
Consider a US-based corporation that on January 1st, 2019 issued bonds with a face value of $10,000 per and a coupon rate of 12% with semi-annual payments. The investor would therefore receive a coupon payment of $ 10,000 12% 6/12 = $ 600 per six months. The question "When are the coupons paid?" has been raised.
There can be various possibilities:
- Exactly six months after January 1, 2019, we will have June 1, 2019.
- Assuming a non-leap year, there are 365 days in a year, resulting in 182.5 days for half a year. Therefore, for a coupon payment, the date would be July 2nd.
- Another standard dictates that a month has 30 days. The date of coupon payment in this instance is May 31, 2019.
Which coupon date should an investor trust? The day count convention is applied in this case. The bond's issuer selects one of the two conventions and informs investors of the pertinent dates.
- A day-count convention is a systematic approach to figuring out how many days there are between two dates.
- While interest on bonds and notes issued by the U.S. Treasury is calculated on an actual/actual basis, interest on the majority of money market deposits and floating-rate notes is computed using the actual/360 day-count approach.
- While the floating-rate leg employs some version of an actual/360 or 365 day-count convention, the fixed-rate leg of an interest rate swap and the majority of fixed-rate bonds utilize either the 30/360 or 30/365 day-count standard.