There are two primary sources of capital available to an organization: Equity and Debt. Equity comprises of equity share capital, preference share capital or retained earnings while Debt comprises of bonds and long term notes payable. In simple words bonds are debt obligations which represent loan raised typically by government or corporate houses. Bonds are referred to as fixed income securities as the provider of funds can contemplate the cash inflows in form of interest and principal payments if a bond is held until maturity. Bond valuation on the other hand is determination of the bonds worth considering the future cash flows it would generate. The need for bond valuation arises in order to decide whether to invest in the bond or not. This article throws light on bonds and their valuation.
Key Bond Attributes
Although there are different types of bonds with differing characteristics, however, some common attributes inherent in all bonds are as follows:
- Face Value/Par Value: The price at which the bond is sold to investors or the amount received at maturity. It is usually in the multiples of $1000.
- Coupon Rate: It is the fixed percentage of par value received by the lender as periodic interest payments. This fixed percentage is called coupon rate.
- Maturity: A bond’s maturity or maturity date is the date on which the bonds principal amount is repaid to the investor.
Factors Affecting Bond Valuation
Bonds are complex instruments when compared to common stocks. This is due to the fact that bond prices are more sensitive to inflation rate or general interest rates. Some of the common factors that affect bond valuation are:
- Interest Rates: Generally, Interest rates and bond prices depict an inverse relationship. Eg: Mr.X is holding a bond of face value $1,000 which yields an interest of 10%. Suppose interest rates rise from 10% to 11%. Now a new bond of same face value will offer interest of $110 as compared to $100 from old bond. Here, the investor being rational would prefer to buy the bond offering 11% interest. Therefore, in order to sell the 10% bond, the issuer will have to offer the bond at a lower price so that the bond generated return approximately equal to 11%. Similarly, if interest rates drop, bond price will increase.
- Inflation: Likewise, bond price and inflation rates also portray inverse relationship. As inflation goes up purchasing power of future interest payments reduces. This makes the bond less attractive and its prices drop.
- Credit Ratings: Credit ratings are assigned to bond issuers and to bonds by credit agencies. These ratings provide an evaluation of the credit worthiness of the issuer. Higher the rating, the better it would be priced.
How to Value?
A bond’s value is equivalent to sum of present value of all future expected cash flows. Before going through the entire process of valuing a bond, let us understand the concept of Yield to Maturity (YTM) and Yield to Call (YTC).
Yield to Maturity
YTM is the discount rate at which the present value of bond, i.e., current price of bond is equal to the sum of present value of all future payments in form of interest and principal. The concept assumes that all payments to be received by investor would be on timely basis and the bond will be held upto maturity.
Yield to Call
Some bonds (called callable) are issued which are called upon by the issuer before the maturity date. This implies that the issuer can redeem the bond before it matures. This pre-mature date is called the call date. Yield to call is therefore the yield on a bond if you hold it upto the call date.
Getting back to our initial discussion of valuation of bonds, pre-requisites required of valuation are estimation of future expected cash flows and required rate of return for discounting these cash flows. The required rate of return is generally the Yield to Maturity (YTM). Once both of these are determined the present value of future cash flows is calculated using the below formula:
After this, all the present values are summated which gives the value of the bond. Hence, the formula is,
Following example provides an overview of the entire process of bond valuation. All the coupon payments at different time periods are discounted using the required rate of return. Last year cash inflow would include both face value and coupon payment.
Valuation of a Zero-Coupon Bond
A Zero-coupon bond is one which is issued at a price much below the face value, redeemed at full face value and offers no interest.
After one does an independent valuation of bond, the value so derived is compared with the market value. If market price is greater than the bond valuation, then the bond is undervalued and you should buy the bond. Also, if market price is lower than the bond price, then bond is overvalued and you should sell the bond.