A day-count convention is a process that aids in the task of establishing a set standard for the calculation of interest accrued between coupon dates, with a focus on the actual days that remain between the current date and the next coupon date associated with the investment. The process may utilize actual dates based on the calendar year or utilize a system that assumes an average number of days in each month. Since various approaches to the day-count convention are used by different bond markets, it is important for the investor to understand the convention or standard that is used when attempting to project the return that the bond will ultimately generate.
One of the more common approaches to a day-count convention is basing the strategy on the assumption that there are 30 days in every month associated with the calendar year. This is important to how interest is accrued on the bond issue, since it will normally be structured as an annual rate that is applied incrementally for each 30-day period. By knowing that this standard is used rather than a calendar year for accruing interest each month, an investor is able to track how much of a return will be generated by the next coupon date.
In like manner, if the day-count convention or standard is based on the calendar year, the assumption will include a 365-day annual period with varying days in each month. This means that some months will accrue interest based on 31 days, others on 30 days, and the month of February on either 28 or 29 days. By being aware that this standard is used, the investor can allow for the variances in months and realize that the interest accrued on the bond will vary month to month, based on the differences in the actual number of days included in those months.
The key issue with a day-count convention is to know which standard is used, and be prepared to utilize that standard when projecting the accrued interest that will be earned each period. Since more than one standard or convention is in use, investors must determine which approach serves as the standard for the bond market in which the asset is traded. Doing so makes it possible to avoid assumptions about how the interest is accrued and ultimately the returns that are projected for the investment, allowing the investor to make an informed decision of whether or not to move forward with the purchase.