GILTS: Dirty vs Clean Pricing?

When investing in UK government bonds, also known as gilts, understanding the different pricing mechanisms is essential. Two terms that often come up in the world of gilts are clean pricing and dirty pricing. These terms refer to how accrued interest is handled when trading gilts.

What is Clean Pricing?

Clean pricing refers to the price of a gilt excluding any accrued interest. It represents the bond's price purely based on its market value, without taking into account the interest that has accumulated since the last coupon payment.

How Clean Pricing Works

When you buy a gilt, the clean price shows the value of the bond as determined by supply and demand in the market. This price does not include the interest that the seller has earned but not yet received. If a bond is trading at its clean price, the buyer will need to add the interest to compensate the seller for the accrued interest.

Example:

Let’s assume a gilt has a coupon (interest payment) of 4% per annum and makes payments twice a year. If you purchase the bond halfway through the interest period, you’ll pay the clean price, and in addition, you’ll owe the seller half of the yearly interest to cover the accrued interest.

Key Features:

• Excludes accrued interest.
• Reflects the underlying market value of the bond.
• Buyers must calculate and pay for any accrued interest separately.

What is Dirty Pricing?

Dirty pricing, on the other hand, refers to the price of a gilt including the accrued interest. It is the total price that the buyer pays to the seller, incorporating both the clean price and the interest that has accumulated since the last coupon payment.

How Dirty Pricing Works

Dirty pricing simplifies the transaction by showing the total cost of the gilt, which includes both the market value (clean price) and the accrued interest. This is the amount the buyer will pay to the seller when purchasing the bond. For practical purposes, dirty pricing is often used in the actual transaction as it shows the all-in price.

Example:

Using the same gilt with a 4% coupon paid twice a year, if you buy the bond halfway through the interest period, the dirty price will be the clean price plus 2% accrued interest, representing the total amount you need to pay.

Key Features:

• Includes accrued interest.
• Reflects the total cost to the buyer.
• Useful for knowing the full transaction cost upfront.

Key Differences Between Clean and Dirty Pricing

• Accrued Interest: The main difference is that clean pricing excludes accrued interest, while dirty pricing includes it.
• Price Visibility: Clean pricing reflects the gilt's pure market value, while dirty pricing provides the full cost of the transaction.
• Transaction Simplicity: Dirty pricing makes transactions simpler for buyers by showing the total amount to be paid, while clean pricing requires a separate calculation of accrued interest.

When is Each Used?

• Clean pricing is often used by traders and analysts to evaluate the bond’s underlying value, as it strips out any interest effects and gives a clearer view of the bond's true market value.
• Dirty pricing is more common in actual transactions, as it shows the total cost the buyer will pay, making it easier to understand the all-in price for purchasing the gilt.

Things to Consider

When buying or selling gilts, it’s important to understand whether the price quoted is clean or dirty. Here are some key points to keep in mind:

• Accrued Interest: Be aware that accrued interest will be added on top of the clean price.
• Quoted Prices: Always check whether the price being quoted by your broker is clean or dirty to avoid any surprises at the point of purchase.
• Tax Implications: The interest element in dirty pricing may have tax implications, so ensure you understand how accrued interest will affect your tax liabilities.

Conclusion

Understanding the difference between clean and dirty pricing is crucial for any investor dealing with gilts. Clean pricing provides the market value, excluding accrued interest, while dirty pricing gives the total cost of the transaction. Both are important depending on whether you’re analysing the bond’s value or completing a transaction. By knowing which pricing method is being used, you can make more informed investment decisions and avoid unexpected costs.