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.
Bond Valuation Factors
Determining the bond valuation 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.
Interest rates and bond prices are inversely related: when interest rates go up, bond prices go down, and vice versa. This is interest rate risk, which can impact the price and performance of your fixed income investments. Duration is a measure of interest rate risk that tells you approximately how much the price of your bond or bond portfolio will change for a 1% change in interest rates. Expressed in years, it is a single number that summarizes cash flows (coupon payments), the timing of cash flows (term to maturity), and the interest rate used to discount those cash flows. There are different formulas to calculate duration, the most common of which are Macaulay duration and Modified duration.
Bond Valuation and its Importance
The bond valuation is dependent upon a number of different factors, which interact to determine how much value a specific bond has. That will in turn affect its suitability for investors. As a result, valuing bonds correctly is an integral step in the investment process.