Day Count Conventions
Peeking into the bond market we have found a few quirky terminology and interesting practices. As the market has developed it has grown some peculiarities and many conveniences and eased the investor’s participation. Of course, this has been beneficial and profitable to the investor community, even as the issuer government and corporate have found easier and cheaper access to working capital. Operational costs have also dropped, thanks to the very active implementation of innovations by the regulators.
While the retail investor, as we have seen recently, invests based on the “dirty price” of a bond. The investor agrees to the price of the bond and has just a single-window settlement. The price is paid, and the bond is swept into her Demat account. All subsequent action on the bond, from regular payment of coupon and settlement of the maturity amount, is done by the issuing corporate (or government) directly into the bank account designated by the investor.
The ”clean price” transaction that is an institution’s mainstay is also settled promptly for the base price of the bond. The online trading system calculates the yield to maturity of the bond based on the bid, or offer price, or the price based on the yield entered.
The accrued interest is settled later when the interest is received. The holder of the security when the interest is received will retain her share of the interest-based on the number of days she has owned the security. The others who have owned it since the last interest payment will receive their share of the interest depending on the number of days for which they have held the bond. There are a few conventions that the market follows in calculating the interest. These conventions to calculate the amount of interest that has accrued between two dates were developed to make the math easy. Their use has persisted even in the time of electronic devices that can make very complex and detailed calculations.
Thirty days hath September, April, June, and November, all the rest have thirty-one. February has twenty-eight, but leap year coming one in four February then has one day more
is a rhyme that many of us learnt in primary school. The regulators have idiot-proofed even this in a system that makes for a process easier than in primary school. (In addition, a lot else has been done to make the investment process safer, simpler, cheaper, superior, and inviting to investors). The market has a few options for calculating the quantum of interest that is owed to earlier owners of the bond. These follow “day count conventions”.
The day count conventions available rather followed are:
Actual/365. This considers the actual number of days a bond is held in a year of 365 days.
Actual/ Actual caters to a leap year and considers February 29th for the holder of the bond on that date.
Actual/ 360 makes for easier arithmetic and considers a year as having 360 days. This is normally used in calculating the accrued interest for commercial paper, T-bills, and other short-term debt instruments that have less than one year to expiration. It considers the actual number of days the paper is held, divided by 360.
30/ 360 is the convention that is most commonly used, including in India. It considers a year to have 360 days of 12 equal months, each having 30 days. In India, the day count convention for G-Secs is 30/360 (RBI website).