Bonds are a crucial component of the global financial market because they give governments and businesses an easy way to raise capital and give investors a low-risk alternative to stocks and other assets.
The price of a bond changes in response to changes in interest rates in the economy. Bond prices decline when interest rates rise to equalize the bond’s interest rate with market rates and vice versa.
What is a bond’s value and how is it determined?
A bond is a type of loan where the bondholder lends money to a corporation or the federal government. The lenders earn interest, and the borrowers get the cash they need. Bond valuation is figuring out a bond’s fair price or value. It involves calculating the present value of a bond’s expected future coupon payments, or cash flow, and the bond’s value upon maturity, or face value.
Because a bond’s par value and interest payments are fixed, an investor uses bond valuation to determine the rate of return necessary for a specific bond investment to be profitable.
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The value of a bond is determined by the interest it pays and by what’s happening in the economy. In most cases, once a bond is issued, its interest rate doesn’t change, even though market interest rates do. If the bond is paying more interest than new bonds with the same credit risk and term, you, as an investor, may be willing to pay more than its face value to own it. If the bond is paying less, the reverse is true. Interest rates and bond prices fluctuate like two sides of a seesaw. As the table below illustrates, when interest rates drop, the price of existing bonds usually goes up. When rates climb, the price of existing bonds usually falls.
What affects the value of bonds?
The most influential factors affecting a bond’s price are prevailing interest rates, yield, and rating.
Changing interest rates
Generally, when inflation is up, the money supply is tightened, and interest rates go up. And conversely, when inflation is low, interest rates drop because more money is available. So the change in market interest rates causes bond prices to move up or down.
Those price fluctuations produce much of the trading that goes on in the bond market. Suppose that a corporation floats a new issue of bonds paying 6% interest, and if it seems like a good investment, you buy some bonds at the full price, or par value, of $1,000 a bond. Two years later, interest rates are up. If new bonds pay 8% interest, no buyer will pay full price for a bond paying 6%. You’ll have to offer your bonds at a discount or less than you paid to sell them. If you must sell, you might have to settle for a price that wipes out most of the interest you’ve earned.
But consider the reverse situation. If, three years later, new bonds offer only 3% interest, you’ll be able to sell your 6% bonds for more than you paid – since buyers will pay more to get a higher interest rate. That premium, combined with the interest payments for the last three years, provides your profit or total return.
The relationship of the yields on bonds of the same credit quality but different terms can be represented as a yield curve, a graph created by plotting the yields of long- and short-term US Treasury issues, which are backed by the creditworthiness of the US government.
Normally, longer-term bonds provide a higher yield, resulting in a positive curve – higher to the right. But if short-term rates are higher, the curve moves the other way – higher to the left. That’s a negative or inverted curve, and it’s more unusual. In other cases, the line is essentially flat. That happens when there is very little difference in yields between the shortest and the longest maturities. The structure of the current yield curve is one of the market indicators bond analysts evaluate to determine where interest rates are headed.
The bond’s rating
When corporations and governments issue bonds, they typically receive a credit rating on the debt’s creditworthiness from each of the three major rating agencies: Standard & Poor’s (S&P), Moody’s Investors Service, Inc., and Fitch Ratings. These companies assess the creditworthiness of a bond issuer or an issue rather than the bond’s market appeal.
They look at other debt the issuer has, how fast the company’s revenues and profits are growing, the state of the economy, and how well other companies in the same business (or municipal governments in the same general shape) are doing. The rating services evaluate sovereign, municipal, corporate, and international bonds, structured products, and mortgage-backed securities (MBS).
Credit ratings can sometimes impact the interest rate an issuer must pay to attract investors. In bonds with the same maturity, the higher the bond’s rating, the lower its interest and yield.
What is Yield?
Yield is what you earn, expressed as a percentage of your investment. There are several ways to measure yield, so knowing which one you’re looking at when you compare bonds is essential. Coupon yield is the most basic type. It’s calculated using the face value of the bond as the price, and the yield is always the same as the bond’s interest rate or coupon. You can use this ratio to find coupon yield and current yield.
But you probably won’t pay par if you buy a bond in the secondary market. The current yield is based on the bond’s current, or market, price. One yield measurement widely quoted by bond tables and brokers is a more complicated calculation known as yield to maturity (YTM). As the name suggests, YTM accounts for all a bond’s earnings, on a percentage basis, from the time of the calculation until it matures.
Annual interest / Price = Yield
You can use this ratio to find coupon yield and current yield.
YTM includes the money you’ll gain or lose (based on the price you paid) when par value is returned, all the interest the bond pays over its lifetime, and interest-on-interest, which is what you’d earn by reinvesting payments at the same coupon rate. Because YTM assumes both that you reinvest every single payment at the same rate and that you hold the bond to maturity, your chances of actually realizing the YTM rate are slim. But it’s a way to estimate a bond’s total earnings potential. For example, you might compare the YTM for two bonds you consider possible investments.
What’s a Bond’s Face Value?
A financial term known as “face value” means a security’s nominal or dollar value, as stated by its issuer. The amount the issuer will give the investor at maturity is known as the face value, also referred to as the par value. While the face value of a bond remains fixed, market fluctuations in interest rates can cause its price to change.
The market value of a stock or bond is not represented by its face value because it is based on supply and demand principles and is frequently determined by the price at which investors are willing to buy and sell a particular security at a given moment. As a result, there may be little correlation between the face value and market value, depending on the state of the market.
If the bond’s interest rate or yield is higher than the current rates in the bond market, an investor may be willing to pay more than the bond’s face value. The investor is essentially paying more to receive higher returns.
Figuring a Bond’s Value by Inna Rosputnia
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