Bond Valuations:: What Does "Bond Valuation" Mean?

Bond Valuations:
Bonds are long-term debt securities issued by companies or government entities

to raise debt finance. Investors who invest in bonds receive periodic interest
payments, called coupon payments, and at maturity, they receive the face value
of the bond along with the last coupon payment. Each payment received from
the bonds, be it coupon payment or payment at maturity, is termed as cash flow
for investors.
 WHAT DOES “BOND VALUATION” MEAN?
Bond valuation is a method to determine the fair value of a bond.
The fundamental principle of bond valuation is that its value is equal to the sum
of present value of its expected cash flows.
The method for valuation of bonds involves three steps as follows:
Step 1: Estimate the expected cash flows
Step 2: Determine the appropriate interest rate that should be used to discount
the cash flows.
& Step 3: Calculate the present value of the expected cash flows (step-1) using
appropriate interest rate (step- 2) i.e. discounting the expected cash flows
Let’s expand and understand each step in detail:
 STEP-1 – ESTIMATING CASH FLOWS
Cash flow is the cash that is estimated to be received in future from investment
in a bond. There are only two types of cash flows that can be received from
investment in bonds i.e. – coupon payments and principal payment at maturity.
The usual cash flow cycle of the bond is coupon payments are received at
regular intervals as per the bond agreement, and final coupon plus principle
payment is received at the maturity. There are some instances when bonds don’t
follow these regular patterns. Unusual patterns maybe a result of the different
type of bond such as zero-coupon bonds, in which there are no coupon
payments. Considering such factors, it is important for an analyst to estimate
accurate cash flow for the purpose of bond valuation.
 STEP-2 – DETERMINE THE APPROPRIATE INTEREST RATE TO

DISCOUNT THE CASH FLOWS
Once the cash flow for the bond is estimated, the next step is to determine the
appropriate interest rate to discount cash flows. The minimum interest rate that
an investor should require is the interest available in the marketplace for
default-free cash flow. Default-free cash flows are cash flows from debt security
which are completely safe and have zero chances default. Such securities are
usually issued by the central bank of a country, for example, in the USA it is
bonds by U.S. Treasury Security.
Consider a situation where an investor wants to invest in bonds. If he is

considering to invest corporate bonds, he is expecting to earn higher return
from these corporate bond compared to rate of returns of U.S. Treasury
Security bonds. This is because chances are that a corporate bond might
default, whereas the U.S. Security Treasury bond is never going to default. As
he is taking a higher risk by investing in corporate bonds, he expects a higher
return.
One may use single interest rate or multiple interest rates for valuation.
 STEP-3 – DISCOUNTING THE EXPECTED CASH FLOWS
Now that we already have values of expected future cash flows and interest rate
used to discount the cash flow, it is time to find the present value of cash flows.
Present Value of a cash flow is the amount of money that must be invested today
to generate a specific future value. The present value of a cash flow is more
commonly known as discounted value.
The present value of a cash flow depends on two determinants:
 When a cash flow will be received i.e. timing of a cash flow &;
 The required interest rate, more widely known as Discount Rate (rate as
per Step-2)
First, we calculate the present value of each expected cash flow. Then we add
all the individual present values and the resultant sum is the value of the bond.
The formula to find the present value of one cash flow is:
 PRESENT VALUE FORMULA FOR BOND VALUATION
Present Value n = Expected cash flow in the period n/ (1+i) n
Here,
i = rate of return/discount rate on bond

n = expected time to receive the cash flow
By this formula, we will get the present value of each individual cash flow t
years from now. The next step is to add all individual cash flows.
Bond Value = Present Value 1 + Present Value 2 + ……. + Present Value n
EXAMPLE
A bond that matures in 4 years has a coupon rate of 10% and has a maturity
value of US$ 100. The bond pays interest annually and has a discount rate of
8%.
Answer:
Year Cash Flows Disc Factor Present Value
1 10 0.9259 9.2593
2 10 0.8573 8.5734
3 10 0.7938 7.9383
4 110 0.7350 80.8533
TOTAL PV 106.6243
WHY BOND VALUATION?
There are many factors such as inflation, credit rating of the bonds, etc. that
affect the value of bonds. Furthermore, there are many features of the bond
itself determines its intrinsic value. As an investor it is important to be fully
aware of what we are investing in, what are the risks involved and how much
returns can we expect. Bond valuation tries to take into consideration all the
features to determine an accurate present value. This present value can be very
helpful for investors & analysts to make an informed investment decision.
From Ref:
Link: https://efinancemanagement.com/investment-decisions/bond-valuation
What is Bond Yield?
How Do Investors Measure Bond
Yield?
The yield concept provides a common bond metric that lets investors compare
securities of different kinds and maturities, regarding the returns they offer. The
coupon rate describes interest payments based on the face value.
Yield figures, however, represent the effective return rate to the investor, taking
into account the actual bond purchase price, future interest earnings, and (in
the case of yield to maturity) the issuer's face value repayment at maturity.
The reason that investors turn to yield metrics, in addition to the coupon
interest rate, should become more evident after considering the following
example.
 Consider for instance an investor who buys a bond with an 8% coupon

rate and a face value of $10,000.
 Suppose also the investor buys the bond in the secondary market for
$8,500.
Even though the investor bought it for $8,500, it still returns $800 in interest
each year (8% of the par value, $10,000, paid in $400 increments twice
yearly). These figures suggest that the investor's $8,500 purchase is gaining an
"effective" return somewhat above 8% of the purchase price. But what is the
real, effective return rate? That is, what is the yield? What is the percent yield
formula?
[P.T.O.]
What is Bond Current Yield?
Understanding the Most Straightforward Bond
Metric
The Current yield for a bond is merely the annual interest payment,
expressed as a percentage of the purchase price. Current yield does
not consider any gains or losses for the investor when the purchase
price and face value payout at maturity are different.
Consider, for example, a purchase with these characteristics:
• Face value (par): $10,000
• Maturity: 10 years after issue
• Interest rate (coupon rate) paid: 8%
• Interest payment: semi-annual (2 times per year)
What is Current Yield When Price Equals Par?

For the investor who buys at face value (par), the current yield and
coupon rate are the same. A $10,000 security, with a coupon rate of
8%, and bought for $10,000, provides $800 interest annually. The
investor's annual return as a percentage of the investment
(Current yield) is 8%.
What is Current Yield When Price is Below Par?

If the investor buys the $10,000, 8% security in the example above at
a market price of $8,500, it will still pay $800 per year interest.
As a result, this makes a current yield of $800 / $8,500, or 9.4% (940
basis points).
A drop in the price below par would likely occur, for instance, if
interest rates in the economy in general rise. Now, only at the below-
par cost does the bond offer investor return rates that compare
favourably to new, higher rates available with other potential
investments.
What is Current Yield When Price is Above Par?
If the $10,000, 8% instrument were purchased at a market price of $11,000,

current yield would be $800 / $11,000, or 7.3% (730 basis points).

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Bond Valuations:

Bonds are long-term debt securities issued by companies or government entities

 WHAT DOES “BOND VALUATION” MEAN?

Bond valuation is a method to determine the fair value of a bond.

The method for valuation of bonds involves three steps as follows:

Step 1: Estimate the expected cash flows

Let’s expand and understand each step in detail:

 STEP-1 – ESTIMATING CASH FLOWS

 STEP-2 – DETERMINE THE APPROPRIATE INTEREST RATE TO

Consider a situation where an investor wants to invest in bonds. If he is

 STEP-3 – DISCOUNTING THE EXPECTED CASH FLOWS

The present value of a cash flow depends on two determinants:

 PRESENT VALUE FORMULA FOR BOND VALUATION

Present Value n = Expected cash flow in the period n/ (1+i) n

i = rate of return/discount rate on bond

Bond Value = Present Value 1 + Present Value 2 + ……. + Present Value n

WHY BOND VALUATION?

 Consider for instance an investor who buys a bond with an 8% coupon

What is Current Yield When Price Equals Par?

What is Current Yield When Price is Below Par?

What is Current Yield When Price is Above Par?

If the $10,000, 8% instrument were purchased at a market price of $11,000,

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