What is 'Bond Valuation'

Bond valuation is a technique for determining the theoretical fair value of a particular bond. Bond valuation includes calculating the present value of the 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 par value. Because a bond's par value and interest payments are fixed, an investor uses bond valuation to determine what rate of return is required for a bond investment to be worthwhile.

BREAKING DOWN 'Bond Valuation'

Characteristics of a Bond

A bond is a debt instrument that provides a steady income stream to the investor in the form of coupon payments. At maturity date, the full face value of the bond is repaid to the bondholder. The characteristics of a regular bond include:

  • Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which is paid to bondholders semi-annually. 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 the bond matures, the bond issuer repays the investor the full face value of the bond. For corporate bonds, the face value of a bond is usually $1,000, and for government bonds, face value 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 at a discount, that is, below par. However, the bondholder will be paid the full face value of the bond at maturity even though he 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 in order to determine its intrinsic value. Like a stock, the value of a bond determines whether it is a suitable investment for a portfolio and hence, is an integral step in bond investing.

Bond valuation, in effect, is calculating the present value of a bond’s expected future coupon payments. The theoretical fair value of a bond is calculated by discounting the present value of its coupon payments by an appropriate discount rate. The discount rate used is the yield to maturity, which is the rate of return that an investor will get if s/he reinvested every coupon payment 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

Calculating the value of a coupon bond factors in the annual or semi-annual coupon payment and the 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:

Where C = future cash flows, that is, coupon payments

r = discount rate, that is, yield to maturity

F = face value of bond

t = number of periods

T = time to maturity

For example, let’s find the value of a corporate bond with annual interest rate of 5%, making semi-annual interest payments for 2 years, after which the bond matures and the principal must be repaid. Assume a YTM of 3%.

F = $1000 for corporate bond

Coupon rateannual = 5%, therefore, Coupon ratesemi-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

Present value of semi-annual payments = 25/(1.03)1 + 25/(1.03)2 + 25/(1.03)3 + 25/(1.03)4

= 24.27 + 23.56 + 22.88 + 22.21

= 92.93

Present value of face value = 1000/(1.03)4

= 888.49

Therefore, value of bond = $92.93 + $888.49 = $981.42

Zero-Coupon Bond Valuation

A zero-coupon bond makes no annual or semi-annual coupon payments 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, we only need to find the present value of the face value.

Following our example above, if the bond paid no coupons to investors, its value will simply be:

$1000/(1.03)4 = $888.49

Under both calculations, a coupon paying bond is more valuable than a zero-coupon bond.

  1. Bond Discount

    Bond discount is the amount by which the market price of a bond ...
  2. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  3. Coupon Rate

    Coupon rate is the yield paid by a fixed income security, which ...
  4. Deep-Discount Bond

    A deep-discount bond is a bond that sells at a significant lesser ...
  5. Par Value

    Par value is the face value of a bond, or for a share, the stock ...
  6. Current Yield

    Current yield is the annual income (interest or dividends) divided ...
Related Articles
  1. Financial Advisor

    Present Value Of Different Bond Types Using Excel

    To determine the value of a bond today - for a fixed principal (par value) to be repaid in the future - we can use an Excel spreadsheet.
  2. Investing

    Comparing Yield To Maturity And The Coupon Rate

    Investors base investing decisions and strategies on yield to maturity more so than coupon rates.
  3. Investing

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  4. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  5. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  6. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  7. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  8. Investing

    Bond Portfolios Made Easy

    Bonds have typically been viewed as stocks' less-glamorous sidekick, but they deserve a little more respect from investors.
  1. When is a bond's coupon rate and yield to maturity the same?

    Find out when a bond's yield to maturity is equal to its coupon rate, and learn about the components of bonds and how they ... Read Answer >>
  2. How do debit spreads impact the trading of options?

    Find out what it means when a bond has a coupon rate of zero and how a bond's coupon rate and par value affect its selling ... Read Answer >>
  3. What is the most common solvency ratios used in fundamental analysis?

    Learn about the difference between a bond's coupon rate and its yield rate, how the coupon rate influences market price and ... Read Answer >>
Hot Definitions
  1. Entrepreneur

    An Entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture. ...
  2. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  3. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  4. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  5. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  6. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
Trading Center