What is Bond Valuation?
Bond valuation is a process or strategy that is used to identify the fair market value of a given bond issue. This process involves allowing for the present value of the interest payments connected with the bond, as well as the total value of the issue at the point of maturity, known as face value. Identifying the bond valuation makes it possible for an investor to determine if the overall return from the investment is worth the time and money required to acquire the bond and hold it all the way to maturity. While bond valuation can be calculated by hand, many investors choose to employ a financial advisor or use the aid of a bond valuation calculator, which can be used free of charge on the Internet; regardless of how it is calculated, it is necessary to know basic information regarding the bond, such as amount and dates of interest payments, the discount rate of payments, the maturity date, and the par value at maturity.
The process of bond valuation takes into consideration the cash flow, or interest payments, connected with the bond issue. Typically, the cash flow is realized from the interest payments that are made on the bond at regularly scheduled intervals. This in turn is related to the par value of the bond, or the face value that the bond holds at the time it reaches maturity. By approaching the overall worth of the investment from both these angles, it is easier for an investor to evaluate the issue and decide if it is worth his or her time, or if another investment option should be selected.
There are multiple, in-depth calculations that may be used to figure bond valuation. Under the relative pricing approach, the face value of a bond is often determined by comparing the bond to a standard bond, usually one issued by the government; the credit rating of a bond with comparable maturity dates and cash flow can be used to determine a bond's fair market value. Arbitrage-free pricing involves subtracting each cash flow payment separately; the amount is determined by the rate of a zero-coupon bond on the same date the interest payment is made. Another option, the stochastic calculus approach, recognizes the possibility of fluctuating interest rates and uses a partial differential math equation to determine a bond's fair market value. The equations for each of these processes can be found online, or calculated on the Internet by use of a free financial calculator; a financial advisor is often very helpful when trying to determine the most accurate value of a bond.
Engaging in bond valuation can be somewhat more complicated if the rate of interest connected with the investment opportunity is variable rather than fixed. In this scenario, the task is to project movements in the marketplace and how those movements will impact the prevailing interest rate. Relating those projections to the bond’s performance provides an informed idea of the amount of interest that will be earned at each of the points during the bond’s life in which disbursements are made to investors. Many investors focus on the worst-case scenario when the interest rate is floating or variable, and make decisions based on the minimum amount of return they can expect as a result of purchasing the bond issue.
Things to Consider
While bond valuation does play a major role in the investor’s decision to purchase the issue, there are other factors to consider. As any bond buyer knows, bonds carry a low amount of volatility or risk in comparison to other investment vehicles. Still, there is the need to look closely at the financial stability of the entity that is issuing the bond before making any final decisions. Even if the fixed rate of interest connected with the bond is attractive, bond buyers may pass on the deal if the company or municipality issuing the bond is considered a poor risk. Many investors also choose to study the current and past trends of the market interest rate, to help determine whether the value may increase or decrease over time.
@ramcatluvr - I agree with you that it's a hard to understand system. The only bonds I've ever heard about are United States savings bonds and that was from my parents. I don't know how they are calculated, however. Guess that is another wiseGEEK question to research!
Now I see why this business is so tricky and hard to understand, not to mention keep up with, which is why we leave it up to people who are trained to follow this stuff. I think it's interesting that some people have that much trust in other people handling their money.
Many people took a hit on bonds they bought for their children's college education, for example, and got burnt when they lost a lot of value on those bonds within the past few years. To me, this is a glorified gambling system. I don't know how someone could find the time to figure this system out on their own, or where to start, for that matter.
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