Bond Valuation

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.
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 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
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.

Bond Valuation

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What is 'Bond Valuation'

Bond valuation is a technique for determining the theoretical fair value of a

Bond Valuation in Practice

Coupon Bond Valuation

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

r = discount rate, that is, yield to maturity

F = face value of bond

C = 2.5% x $1000 = $25 per period

t = 2 years’ x 2 = 4 periods for semi-annual coupon payments

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

= 24.27 + 23.56 + 22.88 + 22.21

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

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

Zero-Coupon Bond Valuation

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