As a general rule, bonds work by providing bond holders with coupon payments according to a certain, pre-determined payment schedule. In between those coupon payments, interest typically accrues. The amount of accrued interest that is due to a bond holder is usually calculated based on the coupon rate as well as how many days have passed since the last coupon payment was made. In addition, determining accrued interest takes into account the day count convention, which is simply a method of determining how the interest will accrue over a period of time. A dirty price is the cost of the bond as well as any interest that has accrued on the bond in between coupon payment periods.
The dirty price of a bond typically increases as the time to pay out on the next coupon amount approaches. When the coupon payment is made, the dirty price then decreases again because it no longer includes the accrued interest. As the time for the next coupon payment approaches, the dirty price again increases because the accrued interest will continue to accumulate.
In some securities markets, the dirty price of a bond is the price that investors pay to obtain a bond. For example, quoting the dirty price of a bond may occur in some European securities markets. In most major securities markets, however, dirty prices are not commonly quoted to potential bond buyers. Instead, the cost of a bond is quoted based on its clean price.
A clean price is the price of a bond exclusive of any interest that has accrued on the bond in between coupon payments. Typically, clean prices are preferred by potential buyers when receiving bond price quotes, because they tend to be more stable than dirty prices. As a general rule, clean prices shift based on economic grounds. For example, a clean price might change if interest rates move up or down. It might also change depending on whether the bond issuer has good or bad credit.
In contrast, dirty prices are usually more unpredictable. By and large, dirty prices do not depict a bond’s true worth as accurately as clean prices. As with a clean price, a dirty price can change for economic reasons like interest rates or credit. Dirty prices can, however, also change because they are dependent upon how much interest has accrued since the last coupon payment date. This change can occur almost daily, making the bond’s dirty price subject to significant fluctuation.