Bond valuation is a method to calculate the present value of the expected future returns, earnings, or cash flow from a bond investment. An investor who invests in a debt instrument such as a bond uses the valuation method to determine whether the cost of the bond is worth the returns over time.
Bond valuations assist an investor in deciding whether the future yields from the bond investment are suitable for their portfolio. Thus, an investor determines the value of a bond through its trading prices, interest rate, and par or face value. While the bond's interest rates and par value remain the same, changes occur in the bond prices and investors' returns over time.
The bond valuation enables an investor to estimate the present value of their future earnings from interest payments and adds it to the bond's par value or the principal amount.
A bond is a debt instrument, meaning the bond issuer borrows from an investor or lender. In exchange, the bond issuer ensures a fixed interest rate for the period the investor holds the bond. Thus, the interest provides a steady income for the bondholder till the maturity date of the bond. Hence, upon maturity, the borrower repays the bondholder per the face value, less than the face or more than the face value.
On the other hand, a zero-coupon bond will not pay any coupon payments or timely interest to the investor or bondholder. Rather, in the case of a zero coupon bond, the bond price is lowered, or the bond issuer issues the bond at a discounted rate to its face value. Thus, at maturity, the investor receives a guaranteed full amount or par value of the bond. As a result, the difference amount between the purchase price of the bond and the par value at maturity becomes the interest earned by the investor.
Generally, zero coupon bond valuation will result in higher yields to maturity or returns for an investor when the bond matures due to the lower price of the bond at purchase.
A coupon rate is a percentage of the bond's principal amount or par value. Thus, the timely coupon payments consist of this percentage amount payable to the investor at decided periods, i.e., quarterly, semi-annually, or annually. Hence, factors such as bond price, principal value or par value, coupon rate of a bond, and time to maturity are useful determinants for bond valuation.
Stock and bond valuation is affected by numerous factors, including changes in the rates of interest, possibilities of inflation, economic conditions, etc. Let us have a look at some of the factors that affect the bond prices:
The types of bond valuation include traditional, relative, and option-adjusted spread methods.
This is the conventional means that involves two means of evaluating and pricing bonds. These are discounted cash flow and yield-to-maturity methods. The former is the method used to calculate the present value of the future cash flows from a bond. This helps investors in learning about the returns they can expect from an investment they are considering.
In yield-to-maturity, the investors can calculate the returns that they can expect if the bond is held until maturity. In the process, the current price of the bond is considered along with face value, coupon rate, and maturity period. As a result, investors get a chance to compare bonds and decide where to invest.
As the name suggests, this involves evaluating and pricing a bond with respect to or in relation to other bonds in the market. One such method is credit spread analysis where one bond is compared against a benchmark bond in the market. The credit spread calculated helps investors know about the additional risk associated with the bond being analyzed with respect to that benchmark bond.
The relative method assesses a bond in relation to another bond, which is a benchmark in the market, with similar traits and maturity.
This type of bond valuation, as the name implies, offers investors an opportunity to adjust their chance of redemption of the bond before maturity. The investors can use callable and puttable bonds and buy and sell the same as and when they realize the potential for profits associated with the bond they hold in the market.
Let us now look at the bond valuation methods and understand how different determinants contribute. In laypeople's terms, bond prices are an extremely important and basic determinant for bond valuation outcomes. Thus, if the calculated future price of a bond is high, it holds a high value in an investor's portfolio and vice versa.
1) Calculating the value of a single cash flow from future coupon payment by estimating its present value for an investor,
A bond's yield to maturity or discount rate gives the investor an estimate of how their future returns might change due to inflations or currency changes.
Or, to calculate the future price of the bond an investor shall use,
2. Total Annuity Formula or Bond Valuation Formula
This formula helps understand how to calculate an investor's total cash flow or present value of the total annuity by assuming annual or semi-annual coupon payments. This simple formula includes,
Bond valuation explains the utility of a bond for an investor. It helps an investor to make a rational choice while making an expenditure or investment based on the current value of future returns. Hence, investors look to invest in a bond that maximizes their returns through higher bond yields to maximize their utility.
Consequently, in the bond valuation calculation, an investor should have certain crucial information for its calculation. Such as,
Let us now calculate the corporate bond valuation for the investor planning to invest in a bond.
Suppose a 4-year corporate bond is issued with a 12% coupon rate at a $5000 face value. It has a yield to maturity of 10%. According to the bond indenture, coupon payments are payable annually to the investor.
F (v) = $600
= $545.45
Hence, the first annuity payment for the investor shall be $545.45 after one year from the bond purchase.
2. Total Cashflow Formula From Coupon Payments,
= $ 5,316.99 (Price of the bond after four years at maturity or the total cashflow for the investor)
3. Annuity Formula or Bond Valuation Formula
This formula is a rather simple bond valuation calculator to estimate the future bond valuation for an investor that involves,
= $5316.99
Thus, the future price of the bond after four years at maturity is $5316.99.
The advantages of using different bond valuation models to assess the price of the bonds are as follows:
Undoubtedly, evaluating and pricing the bonds is an important aspect of the bond market, but this valuation also has some limitations, which one must know of. Let us have a look at them below:
Although both stocks and bonds are valued using the discounted cash flow method, which assists in calculating the present value of future cash flows from security. However, a major difference between the two securities is that while valuing bond yields, investors will consider interest payments and their future valuation. Thus, bond valuation considers each interest payment segment and adds them to par value.
2. What are bond valuation techniques?The valuation for this debt instrument or security uses the discounted cash flow method to understand the true value for an investor from bond yields, interest payments, and during bond maturity.
3. How do interest rates affect bond valuations?Interest rates represent the market interest rates (MIRs) compared to the interest yields from a bond. The comparison and difference between the two interest rates. i.e., MIR and bond interest rate help an investor estimate the present value of future returns. So if the market interest rates are higher, the investor might not be willing to invest in bonds as they may gain higher returns from other investments. Similarly, if the bond interest rate is higher than MIR, then the bond investment is likely.
This article has been a guide to what is Bond Valuation. We explain its formula, methods, examples, how to calculate it, factors, importance, and risks. You can also go through our recommended articles on corporate finance –
