Bond Valuation

What is Bond Valuation?

Bonds and bond valuation is an important part of numerous finance classes such as corporate finance, introduction the finance, and healthcare finance.  This is because businesses are funded through either equity or debt.  In regards to debt, a popular form of debt in corporate America, or around the world, is issuing bonds.

Bond valuation is the process of identifying the fair market price of a particular bond.  From this evaluation, investors or business owners may identify whether a particular bond is a good deal (underpriced) or overvalued.   Further, corporations may decide, in part, as whether to issue bonds as a way to raise new capital for future projects or use retained earnings (equity) by determining the price of similar bonds in the marketplace.  So, regardless if you are a finance students or finance professional, understanding bond valuation is a critical tool to have in your financial arsenal.

The valuation process for a bond is pretty straightforward.  In a nutshell, the value of the bond is the present value of a bond’s future cash flows plus the terminal value of the final cash flow.  A wonderful quality about bonds is that they have a fixed cash flow for every period and one terminal value at maturity.  From this, each cash flow is discounted by the current interest rate of comparable bonds.  Finally, the terminal value or face value of the bond is then discounted using the same interest rate.  The end result is a present value of future cash flows from the bond.  By summing each present value, investors and students will be able to determine the appropriate price of the bond.

What is a clean and dirty price of a bond?

The clean and dirty price of a bond are common slang terms used when pricing bonds.  The clean price of a bond is the price that does not include accrued interest between bond payments.  For example, if a bond just made an interest payment two weeks ago, most finance students will value the bond using future cash flows and the terminal value.  However, the interest accrued from the previous two weeks is usually not included in the bond price.  This is considered the clean price of a bond.  In contrast, adding the interest accrued from the previous two weeks to the bond price will give you the dirty value of the bond.  From an investor’s perspective, the dirty bond price is a more accurate reflection of the actual price for the bond.  However, finance students are rarely asked to take this additional step in their calculations for bond prices.

Factors Impacting Bond Valuation:

Numerous considerations must be taken into account when value and bonds.  As stated above, each cash flow expected from a bond must be discounted back to present-day dollars. However, the discount rate is difficult for investors and students to identify.  A popular way to identify inappropriate discount rate for bond valuations is by identifying similar bonds that have been issued recently.  From this, investors will use the coupon rate from the newly issued bonds as the discount rate.  Unfortunately, determining which bonds that are newly issued are comparable to the target bond is highly debatable.  A second factor impacting bond valuation is credit worthiness.  Credit worthiness of a bond issuer will determine the market interest rates for their bond valuation.  If a company is facing financial distress, the discount rate will be significantly higher as compared to a company with sound financial standings.  Finally, expected inflation rates will impact on prices inversely.  If interest rates are expected to increase, then discount rates used to value bonds should be lower.  The reasoning behind this concept is that investors looking to buy bonds want the highest possible yield.  If newly issued bonds are paying a higher dividend, then prices of previously issued bonds need to be reduced to be competitive.

Why Is Bond Valuation Important?

The concept of bond valuation is important for several reasons.  First, corporations continually take on new projects. In taking on new projects, companies need to raise funds through two possible avenues, which are either debt and/or equity. When deciding how much debt to use, a market evaluation should be done to determine the current interest rates offered by comparable competitors in the bond market.  With this market interest rate, a competitive bond issuance may be done.  By understanding the bond valuation process, finance professionals will be able to conduct the research and efficient and professional manner.  Next, investors purchasing bonds for fixed income should understand the valuation process.  Currently, there are thousands of potential bonds to purchase for investors with different maturity dates, coupon rates, and face values.  Because of the multitude of options, investors need to understand how to determine the present value of the different bonds.  From this, investors will be able to determine which bond has the highest return with the various risk factors taken into account.  On a final note, bond valuation is a critical concepts in most finance courses.  Usually, bond valuation is covered within the first four weeks of the finance course.  In covering this topic, most professors spend a significant amount of time teaching students how to value bonds in different scenarios.  Regardless if you are a finance professional, fixed income investor, or finance student, understanding the various components and processes related to bond valuation will help you better determine the true or present value of different bonds.

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Who Needs to Know Bond Valuation?

Understanding and applying bond valuation is an important skill for corporate finance professionals, investors, and finance students.  Corporate finance professionals may be able to use bond valuation to determine whether a company should issue bonds and at what discount rate should be included on the bond.  By doing this, companies will be able to issue bonds at the lowest discount rate possible, while still attracting needed investors.  Investors need to understand how to value bonds for a different reason.  As previously stated, there are thousands of potential bond investments.  Because of the multitude of options, determining which bond or bonds are selling at a discount is critical.  By identifying discounted bonds, investors will be able to exploit market opportunities.  This will lead to elevated returns in their perspective portfolios.  Finally, finance students need to understand bond valuation because of the importance instructors place in the concept.  From my experience, instructors for finance tend to stress conceptualization of the bond process in classes. From this, students may receive better grades in their class by mastering the bond valuation process.

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Step by Step Bond Valuation Explained:

Bond Valuation Terminology:

Bond valuation is a popular concept covered in corporate finance, international finance, capital budgeting classes, and investment classes.  Because of the importance of bond valuation, students need to have a firm grasp on the terminology used when calculating the value of bonds.

  • Par value or face value - the dollar amount an investor will receive when a bond matures.  Usually, the part or face value is $1000.  Further, this is also the price original investors pay to the bond issuer for the bond.  However, there are several exceptions to this rule.  A popular exception is a zero coupon bond.
  • Coupon rate - the coupon rate for a bond is interest rates used to calculate bond payments. This interest rate is usually a fixed interest rate.  However, there are a multitude of exceptions to the rule.
  • Coupon payment - the coupon payment is the dollar amounts the investor will receive each payment period.    The payment is calculated by multiplying the face value of the bond by the coupon interest rate.
  • Maturity date - this is the date when the bond issuer returns the face value of the bond to the bond holder.
  • Call price - some bonds have a feature included which allows investors to paid the bonds off early if certain requirements are met.  When this happens, bondholders are often paid a premium over the face value of the bond, which is considered to be the call price.
  • Discount rate - the discount rate, in relation to bond valuation, is the market rate similar bonds are issued.

 

Bond Valuation Formula
Bond Valuation Formula

Bond Valuation- Step by Step:

When calculating the value of a bond, there are two popular procedures investors and students tend to follow.  The first process is by solving the value of a bond by using a financial calculator.  When using the financial calculator, there are certain functions needed which are:

  • N – Number of payments left. This is also known as time to maturity.
  • I – This is the discount rate used to discount future cash flows to present day dollars.
  • PMT – This is your coupon payment. To find your coupon payment, just multiply the face value of a bond by the coupon rate.
  • FV – This is the face value of a bond.

Once the above variables are identified, pressing PV on your financial calculator will solve for the present value or the price of a bond.

The second process used by most students is through the application of the bond valuation formula, which is pictured above.  The variables are as follows:

  • C – This is the coupon payment received every period.
  • I – Discount rate used to bring future values to present day dollars.
  • N – This is the period of time the cash flow takes place.
  • M – Face value of the bond.

To use this formula, first start with identifying the cash flow for each period.    Next, add one to the discount rate.  Once this is complete, raise the one plus discounts to the power of time.  Finally, divide the cash flow by the denominator.  This will give you the present value of the cash flow from that particular period.    Now repeat this process for the other cash flows and also for the terminal value.  Finally, and the present value of all the cash flows together and this gives you the price of the bond.

Concluding Thoughts on Bond Valuation:

Bonds or financial instruments used by corporations, governments, in municipalities to raise funds for capital budgeting purposes.  Valuing a bond is the process of identifying the fair or true market price of a bond in present-day dollars.  In the simplest form, the valuation process starts with identifying future cash flows, a discount rate, and the terminal the value for bond.  From this, cash flows are discounted to present-day dollars using the discount rate and then summed together.  This ends with the price of a bond. This end value is considered to be the clean price of the bond.  To find the dirty price, just add accumulated interest from the previous coupon payment date.

Understanding the bond valuation process is critical for investors, students, and finance professionals.  By understanding this process, individuals will be able to apply the process to real-world situations such as determining if a corporation should issue bonds, whether current bonds issued are a good deal, and solving hypothetical situations related to bond valuation in finance classes.