Chapter 2 What is Bond Basis?
Bond basis is the day count convention that is typically used with fixed income securities. There are a number of different conventions in this category:
Actual/Actual:
The most commonly used convention in bond markets worldwide, actual/actual (used with most government bonds and many corporate bonds) uses a day count fraction equal to the actual number of days in an investment period divided by the actual number of days in a year, which can be 365 or 366 depending on whether it is a leap year or not.
Actual/365:
Actual/365 basis uses a day count fraction equal to the actual number of days in an investment period divided by 365 (the “usual” number of days in a year). This method is used by some supranational and corporate bonds.
30/360:
30/360 uses a day count fraction that assumes there are exactly 360 days in a year. This is commonly used in the US corporate bond market.
Example
James is a fund manager with ABC Asset Management. Recently, he invested USD 1 million in a bond paying an interest rate of 5% annually on a bond basis (actual/actual).
The bond is to be held for one year, at the end of which the fund will receive principal plus interest.
Assuming a non leap year, how much interest will the fund receive after one year?
Answer: USD50,000 (= USD 1,000,000 *5%*365/365).
For the next e-book, let's look at the link between Bond Basis & Money Market Basis and more importantly, how to compare investments which have different day counts and compounding methods.
