Bond valuation principles and methods

Finance

The formula for valuing a bond is:

P0="t"1nIi (1+i) t+PVn (1+i) n=Presentvalueofcouponpayments+Presentvalueofbond'sparvalue

In the scenario given, n=10 in order to get a value of $1,277.98. This price is at a premium, meaning above the par value. Bonds are price above par value when the interest rate on the bond is higher than the interest rate in the market. When the rate in the market is higher than the coupon rate on the bond, the bond will have a price below par value. So in this case, with the price of the bond being $1,277.98, that assumes that for the next ten years, this bond is going to pay a rate higher than what the market rate is at present. Because the bond holder is receiving a premium, the bondholder must pay for that premium. This can present a problem for the bond holder, in that they will receive back a par value that is lower than their initial investment -- that might not look good, even though the reality is that they were receiving a higher coupon the entire time, which they could have been reinvesting. Such a bond is useful in certain circumstances, such as if the buyer believes that interest rates are going to increase. The value of the bond would decline, but it was going to decline anyway, and the reinvestment value will be higher.

There are a number of factors that influence bond valuation. The first is the raw intrinsic value of the bond -- the net present value of the expected future cash flows. This is comprised of the nominal future cash flows, the discount rate and the timing of the cash flows. The second is the risk of the bond -- there is always a risk premium to pay above the risk free rate. The credit rating in this example is evidence that this particular bond is low price, therefore having a minimal risk premium. Another factor is whether or not the bond is callable -- if it is then there will be a discount on the risk to account for the call risk. Another risk factor in the bond is the liquidity in the market -- bonds with higher liquidity risk will come with a discount attached to them to account for that. Another category of risk, interest rate risk, is typically priced in -- expected interest rate moves are already built into the bond price in an efficient market. If a market is particularly volatile, there may be a slight discount to account for the higher than normal interest rate risk to which the bond is subjected.

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There are several types of risks associated with investing in bonds. Among them are interest rate risk, which is the risk that interest rate changes will adversely affect the value of the bonds. Another is purchasing power risk, which operates on a similar principle to interest rate risk. If inflation rises, then the present value of the bond's future cash flows will decline. Business/financial risk is another one, and that is the risk that the bond isn't repaid, or that the debtor will go bankrupt and the bond is paid out at pennies to the dollar. Call risk applies to callable bonds, that the issuer will call them early. This will usually happen with a change in rates in the issuer's favor, implying that the holder loses out -- of course the holder would have priced the call feature into the purchase price of the bond in the first place. A fifth category of risk for bonds is liquidity risk. This is the risk that the bondholder might encounter an illiquid market in trying to sell the bonds, thereby lowering the return.