What is bond valuation?

Definition

The bond assessment determines the fair value of bonds based on maturity and annual interest. It is recommended to accurately determine the value of bonds to make a decision on whether they are a good investment. The current value of the bonds is determined by summing the expected future interest payments and adding the principal amount due to be paid at maturity. The market price of bonds is influenced by several factors, including the bond’s maturity date, the issuer’s ability to repay, and the interest rate at the time of issuance compared to current interest rates. The complexity of correctly assessing bonds makes bond mutual funds a sound alternative for many investors.

How Bond Assessment Works

The face value of a bond is the amount that the issuer pays to the bondholder once the bond matures. The market price of the bond, which equals the present value of the expected future cash flows for the bondholder, changes depending on several factors, including the bond’s maturity date, the issuer’s ability to repay, and the interest rate at the time of issuance compared to current rates. Depending on these factors, an investor may end up buying a bond at face value, below face value, or above face value. For example, a bond with a face value of $1,000 is purchased at a price of $950, which is below the face value.

How to Calculate Bond Value

Here are the steps to take to determine the value of the bond. In this example, you will find the present value of a five-year Treasury bond issued in November 2019.

Determine the amount of each interest payment and the number of remaining payments: If the interest rate on a five-year Treasury bond with a face value of $1,000 issued in November 2019 is 1.62%, it will pay $16.20 annually until maturity (based on one annual payment). If you are pricing this in September 2021, there will be four remaining payments (T in the formula below) because the bond matures in November 2024. The final payment includes the face value of the bond, so the payments will be as follows: year 1: $16.20; year 2: $16.20; year 3: $16.20; and year 4: $1,016.20.

Determine the appropriate discount rate: The above future payments must be discounted to be their present value today. To do this, first look for the current interest rates of newly issued bonds similar to the bond you are pricing. If you want to know the present value of a five-year Treasury bond in 2019, look at the interest rate offered on newly issued five-year Treasury bonds. Use the current interest rate (market rate) as the discount rate (r in the formula below). The interest rate on new five-year Treasury bonds on September 24, 2021, was 0.97%. We will use this as the discount rate.

Determine the present value of each remaining payment: The present value is determined by dividing each payment by (1 + r) t where t represents each remaining payment numbered, and r is the discount rate determined in step 2 in decimal form. For a bond with four remaining payments, t = 1 for the payment next year, and t = 2 for the payment after two years, for example.
– The present value of the next payment = $16.20 / 1.0097 = $16.04
– The present value of the payment after two years = $16.20 / (1.0097)2 = $15.89
– The present value of the payment after three years = $16.20 / (1.0097)3 = $15.74
–
The present value of the final payment = 1016.20 dollars / (1.0097)^4 = 977.71 dollars
Calculating the value of the bond by summing the present values of all future payments: 16.04 dollars + 15.89 dollars + 15.74 dollars + 977.71 dollars = 1025.38 dollars

Source of the interest rate for a five-year Treasury bond: Y Charts

The value of the bond for five years in 2019 in this example is 1025.38 dollars, or 25.38 dollars above the face value. This makes sense because the current interest rate has decreased to 0.97%, which is 0.65 percentage points, or 65 basis points, lower than the 1.62% rate on the 2019 Treasury bond that we priced.

The procedure outlined above is mathematically illustrated in the formula below:
Where T = total number of remaining payments (four)
t = number for each individual payment (1 for the first year, 2 for the second year, etc.)
r = discount rate
And ∑ indicates summing each computed number by substituting 1, 2, 3, or 4 with t.

Note: The calculation used above is based on annual interest payments. To calculate monthly payments, the formula must be adjusted to reflect the larger number of payments.

Investing in Bond Mutual Funds

Clearly, bond valuation is a complex process. For this reason, many individual investors and even some professionals choose to invest their money in bond mutual funds instead. Choosing the right mutual fund begins with identifying your investment objectives and ensuring they align with the objectives of any fund you are considering.

Fidelity Investments suggests three questions to help you determine a suitable bond fund:

How much money will you invest? A short-term timeframe (one year or less) may indicate that you should keep your money in a money market fund. With a slightly longer investment timeframe, a short-term bond fund can provide higher returns than a money market fund. Conversely, if you are an investor with a long-term horizon, you may want to choose a long-term bond fund that may offer higher returns in exchange for bearing market fluctuations.

Are you investing for current income or long-term growth? Investors seeking current income should take a more conservative approach, such as short-term investment-grade bond funds. For long-term growth, investors may look for a multi-sector bond fund that may provide higher returns.

What is your risk tolerance? An investor who avoids risk should invest in money market funds, as they offer higher returns than savings accounts but are typically safer than bonds. Those seeking a higher return and who can tolerate moderate risk may look for short or intermediate-term quality bond funds. Those with a longer timeframe and a higher risk tolerance may seek long-term growth through a multi-sector bond fund with the potential for higher returns.

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Sources: Milken Institute, Y Charts, Buyupside

Source: https://www.thebalancemoney.com/what-is-bond-valuation-5089593

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