What Is Bond Valuation?

Bond valuation determines the present value of a bond's future interest payments, also known as its cash flow, and the bond's value upon maturity, also known as its face value or 澳洲幸运5官方开奖结果体彩网:par value. A bond's par value and interest payments are fixed. Bond valuation helps investors determine what rate of return makes a bond investment worth the cost.

Understanding Bond Valuation

A bond is a debt instrument that provides a steady income stream to the investor in the form of 澳洲幸运5官方开奖结果体彩网:coupon payments. At the maturity date, the full face value of the bond is repaid to the bondholder. The characteristics of a regul🌼ar bond include:

• Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which is paid to bondholders semiannually. The coupon rate is the fixed return that an investor earns periodically until it matures.

Maturity date: All bonds have maturity dates, some short-term, others long-term. When a bond matures, the bond issuer repays the investor the full 澳洲幸运5官方开奖结果体彩网:face value of the bond. For corporate bonds, the face value of a bond is usually $1,000, and for government bonds, the face valꦑue is $10,000. The face value is not necessarily the invested principal or purchase price of the bond.

Current price: Depending on the level of interest rate in the environment, the investor may purchase a bond at par, below par, or above par. For example, if interest rates increase, the value of a bond will decrease since the coupon rate will be lower than the interest rate in the economy. When this occurs, the bond will trade 澳洲幸运5官方开奖结果体彩网:at a discount, that is, below par. However, the bondholder will be paid the full face value of the bond at maturity even though they purchased it for less than the par value.

Bond Valuation in Practice

Since bonds are an essential part of the capital markets, investors and analysts seek to understand how the different features of a bond interact to determine its 澳洲幸运5官方开奖结果体彩网:intrinsic value. Like a stock, the value of a bond determines whether it is a suitableꦰ investment for a portfolio and, hence, is an integral step in bond investing.

Bond valuation, in effect, is calculating the 澳洲幸运5官方开奖结果体彩网:present value of a bond’s expected future coupon payments. The theoretical fair value of a bond is calculated by discounting the future value of its coupon payments by an appropriate 澳洲幸运5官方开奖结果体彩网:discount rate.

The discount rate used is the yield to maturity, which is the rate of return that an investor will get if they reinvest every coupon payme🍬nt from the bond at a fixed interest rate ✱until the bond matures. It takes into account the price of a bond, par value, coupon rate, and time to maturity.

Coupon Bond Valuation

Calcu✃lating the value of a coupon bond factors in the annual or semi-annual coupon payment and th♈e par value of the bond.

🐓The present value of expected cash flows is added to the present value of the face value of the bond as seen in the following formula:

$\begin{aligned} &V_{\text{coupons}}=\sum\frac{C}{(1+r)^t}\\ &V_{\text{face value}}=\frac{F}{(1+r)^T}\\ &\textbf{where:}\\ &C=\text{future cash flows, that is, coupon payments}\\ &r=\text{discount rate, that is, yield to maturity}\\ &F=\text{face value of the bond}\\ &t=\text{number of periods}\\ &T=\text{time to maturity} \end{aligned}$​Vcoupons​=∑(1+r)tC​Vface value​=(1+r)TF​where:C=future cash flows, tꦫhat is,&n♋bsp;coupon paymentsr=discount&nbs🃏p;rate, that is, y🧜ield to maturityF=face value of the bondt=number of periodsT=time to maturity​

For example, let’s find the value of a corporate bond with an annual interest rate of 5%, making semi-annꦿual interest payments for two years, after which the bond matures and𒊎 the principal must be repaid. Assume a YTM of 3%:

• F = $1,000 for corporate bond
• Coupon rate_annual = 5%, therefore, Coupon rate_semi-annual = 5% / 2 = 2.5%
• C = 2.5% x $1000 = $25 per period
• t = 2 years x 2 = 4 periods for semi-annual coupon payments
• T = 4 periods
• r = YTM of 3% / 2 for semi-annual compounding = 1.5%

1. Present value of semi-annual payments = 25 / (1.015)¹ + 25 / (1.015)² + 25 / (1.015)³ + 25 / (1.015)⁴ = 96.36
2. Present value of face value = 1000 / (1.015)⁴ = 942.18

Therefore, the value of the bond is $1,038.54.

Zero-Coupon Bond Valuation

A zero-coupon bond makes no annual or semi-annual coupon paymentღs for the duration of the bond. Instead, it is sold at a deep discount to par when issued. The difference between the 🌼purchase price and par value is the investor’s interest earned on the bond.

To calculate the value of a zero-coupon bond, we only need to find the present value of the face value. Carrying over from the example above, the value of a zero-coupon bond with a face value of $1,000, YTM of 3%, and two years to maturity would be $1,000 / (1.03)², or $942.59.

Explain Like I'm Five

A bond is an investment that returns a fixed interℱest rate. When you buy a bond, you receive periodic interest payments until the bond matures, and then the face value of the bond is returned to you.

Investors use valuation methods to determine if buying a bond is worthwhile compared to other investments. They do that by calculating the value of the future payments, measured in today's dollars. The total is then compared with other potential investments to find the best choice.

The Bottom Line

Bond valuation is an important tool for investors in order to determine the fair value of a bond. Investors analyze coupon payments, yield to matu𒊎rity, and face value to understand if the return on the bond is acceptable, which helps inform investment decisions.

Investors also take into consideration present value, future payments, interest r🐽aꦰtes, and the state of the economy to help make an assessment.