This article focuses on the valuation of bonds and the different factors that go into considering their value.
Valuation and Bonds
The valuation of a bond depends on the size of its coupon payments, the length of time remaining until the bond matures and the current level of interest rates.
Determining the valuation of a bond involves considering the present value of its cash flows (coupons and principal) discounted at a suitable interest rate(s). One convention used to simplify the calculation procedure is to assume a single rate for all cash flows. This is the known as the yield-to-maturity.
Yield to Maturity
For valuation, the concept of yield-to-maturity (YTM) equates the present value of all the cash flows from a bond to the price of a bond. It is an iterative (trial and error) calculation that accounts for the reinvestment of the coupons as well as any capital gain or loss on the price of the bond (which will be redeemed by the issuer at par, $100). Conversely, given the YTM, a price can be calculated. A rise in the YTM will cause the price calculated to decrease, while a fall in the YTM will cause the price to rise. Although it does simplify the calculations, this convention assumes that all the coupons from a bond can be reinvested at the same rate (which is unlikely). The actual return generated by a bond held until maturity depends on the future reinvestment rates at which the coupon payments received are invested.
Duration is a measure of the average (cash-weighted) term-to-maturity of a bond. The value of a bond will vary depending on the amount of the cash flows (coupon size), the timing of the cash flows (term to maturity), and the interest rate used for discounting. Duration helps to summarize these variables in a single number. There are two types of duration, Macaulay duration and modified duration.
Valuation and its Importance
The valuation of a bond is dependent upon a number of different factors, as we have seen. All of these factors interact to determine how much value a specific bond has, which in turn affects its suitability for investors. As a result, valuing bonds correctly is an integral step in the investment process.