Now that you have a basic understanding of what bond ratings are, we’ll look at bond valuation and how you can use it to select your investments.
What is a Bond Valuation?
Bond valuation is a technique for determining the fair price of a bond. The theoretical fair value is the present value of the stream of cash flows expected. Bond valuation includes calculating the present value of the bond's cash flow (future interest payments), and the bond's par value (value upon maturity)
A bond's par value and cash flow are fixed, so investors need simply to look to bond valuation to determine whether an investment in a particular bond would be worthwhile. It's only one of the factors investors consider in determining whether to invest in a particular bond, though. Other important considerations are: the issuing company's creditworthiness, the bond's price appreciation potential, prevailing market interest rates, etc.
Bond Valuation Formula
Firstly, the present value of the bond's future cash flows should be determined. The present value is the amount that would have to be invested today in order to generate said future cash flow. It’s dependent on both the timing of the cash flow and the interest rate. To figure out the value, the present value of each individual cash flow must be found. Then, you’ll simply add the cash flows together.
Image source: Wikipedia
F = face values
iF = contractual interest rate
C = F * iF = coupon payment (periodic interest payment)
N = number of payments
i = market interest rate, or required yield, or observed / appropriate yield to maturity
M = value at maturity, usually equals face value
P = market price of bond
Bond Valuation Calculators
There are many tools available online to help you calculate a bond’s valuation, without having to do that crazy math computation on your own! Here are some popular ones:
There’s a lot to learn about bond valuation. It’s important to be able to understand the fair price of a bond before investing in it. Selecting an investment that is well suited for you can be a stressful experience. We’ve got you covered. Our Investing in Different Markets course will teach you all about bonds.