Bond valuation

A bond is a debt security through which an investor lends money to a company, government or other issuer. In return, the issuer promises specified payments—commonly periodic interest and repayment of principal at maturity. Because many bonds trade after issuance, valuation determines the present price of those promised, but not always certain, cash flows.

When to use it

• To estimate a bond’s value when considering a purchase or sale.
• To assess the cost and attractiveness of raising capital through a bond issue.

Origins

Tradable public debt has a long history. The Republic of Venice used forms of funded government borrowing from the twelfth century, and early trading companies such as the Dutch East India Company issued debt securities. National governments increasingly financed themselves through bonds from the sixteenth century onward. Modern bond markets encompass sovereign, municipal and corporate obligations on an enormous scale, making the valuation and trading of fixed-income cash flows a central part of finance.

What it is

A bond’s value is the present value of its expected future cash flows, applying the time value of money. A conventional bond specifies a principal or face value, a coupon rate and a maturity date. Valuation has three stages:

1st. Estimate the expected cash flows: For a plain fixed-rate bond, the contractual coupons and principal are straightforward. Expected cash flows may differ from contractual amounts when default, restructuring, call provisions or conversion rights are possible. A highly rated sovereign and a repeat sovereign defaulter should not be valued as though the certainty of payment were identical.

2. Select an appropriate discount rate: Required yield reflects the time value of money and compensation for risks including credit, liquidity and optionality. If market yields rise from 2 to 3 per cent, an existing fixed coupon becomes less attractive and its price falls; when required yields fall, price rises. Evidence that an issuer is short of cash normally increases the required credit spread and depresses the bond’s value.
3. Calculate present value: Discount every expected coupon and principal payment at the appropriate rate for its timing and risk, then add the results.

Bonds may be held to maturity for their contractual payments, subject to default and embedded options, or traded in the secondary market. Their prices adjust continually to interest rates, inflation expectations, credit quality, liquidity, supply and demand, tax treatment and contractual features. Some influences belong to the issuer; others reflect the wider market.

How to use it