A Primer on Bonds Valuation


If you follow the bond market, you may find that bond prices generally fall when the economic news is good and increase when they are negative. An understanding of this typical bond assessment may explain the phenomenon.

After reading this document, you will know how bonds are defined, evaluated and traded. There are advantages for bondholders who make bonds a safe and quality investment: investors get fixed amounts of income that are fundamental factors that drive bond price fluctuations. Knowing these factors helps to better understand the underlying economic forces and to evaluate the obligations.

Main characteristics of obligations

A bond is a negotiable debt instrument in which the issuer borrows a particular amount, called the principal. In exchange, the borrower agrees to pay fixed interest, also called coupons, for a given period. Everything is well defined in the bond contract: the coupon rate is the interest rate that the issuer pays to the bearer and the coupon dates are the coupon payment dates. In addition, the issuer will repay the full amount of the principal when the bond reaches what is called a maturity (or due date).

In short, a bond is a securitized loan.

First, we can mention the most relevant point that makes bonds so attractive, especially in dark times for the stock markets. Indeed, the regular payments of interest and repay the value of the principal at the due date. Bonds with maturities of up to one year are called short-term bonds or debts.

Bonds with maturities ranging from one to ten years are called intermediate bonds or intermediate notes. Long-term bonds are issued with a maturity of at least ten years and generally up to 30 years.

A second important aspect is that all the characteristics of the bonds are well defined in advance and that the market offers different choices for each of them: coupon rate (also called coupon yield), date of the Coupon, maturity date may vary from one bond to the other but are known when investing in the given bond. It allows the investor to adapt his investment strategy to an acceptable level of risk and return.

Consider the following example: for a principal value bond of $ 1,000, an annual coupon rate of 5% and a maturity of 2 years. Since the annual coupon is 5%, the issuer of these bonds agrees to pay an annual interest of $ 50 (5% x $ 1,000) per bond. In the second year, the bondholder will receive (per bond) $ 50 + $ 1,000, the coupon and the return of capital. I exactly matches what you can expect if you have purchased the bond as defined in this example and if the issuer of the bond is not in default!

However, at any given time, the value of your bond may fluctuate. Imagine that the market interest rate reaches 6% in the second year of your holding and that new bonds are issued with a coupon rate of 6%. It is clear that new investors will not pay $ 1,000 for a 5% performance bond when they can buy new bonds with a discounted coupon rate of 6% for $ 1,000. What will happen to your specific obligation (with a coupon of 5%)?

It will be sold by many bondholders who are willing to invest in new bonds at 6% and, as a result, the face value of your bond will decrease to make it more competitive with current obligations. Conversely, if interest rates fall, the value of your bond will increase because there will be more buyers.

Intermediate summary

A bond is an investment in the loan in which an investor lends money to an entity (company or government) that borrows the funds for a defined period at a fixed interest rate. Businesses, municipalities, states, and US and foreign governments use bonds to fund various projects and activities. The indebted entity (issuer) issues an obligation stating the interest rate (coupon) to be paid and the time when the loaned funds (principal of the bond) must be surrendered (date d. deadline). Note that bonds have some similarity to deposit certificates (CDs) and savings accounts. Indeed, investors who deposit money on CDs (or savings accounts) lend money to banks. Banks pay investors' interest on their deposits and then repay the principal when the CDs mature.

The risks of investing in bonds

Investing in bonds is not risk free. In fact, each bond investment has certain risks, although their degree of risk varies depending on the type of debt and the issuer.

The main risk is the credit risk (or risk of default). In this scenario, the issuer is not able to pay the interest and repay the principal on pre-established dates. The credit risk then depends on the credit trust of the issuer of the debt. Solvency refers to the ability of the issuer to make scheduled payments and to repay the principal on the due date. Clearly, credit risk varies by bond issuer. US Treasury issues carry virtually no risk of default due to the full confidence of the US government in securing interest and principal payments.

As a direct result, US government bonds will offer a lower return than riskier bond issuers. Indeed, the obligations of the US government are "absolutely" safe and pose no risk. We can not expect big returns.

Another risk is the interest rate risk, only if you do not keep your bond until the due date. We have already mentioned this process in the previous section of this document: bond values ​​vary in a simple way with interest rates. During the high period of interest, if you sell your bonds (bought at a lower yield), you will lose money, only if you sell before maturity.

For bondholders (up to maturity), a major risk is obviously related to the rise in inflation, as this will have a corrosive impact on your bond investment. Indeed, you block your money for a long time, then inflation plays against you. Of course, the longer the maturity, the greater the impact of inflation. Next, we expect some pair trades to be active between short-term and long-term maturities during periods of rising inflation.

The yield curve

The yield curve is defined as the two-dimensional chart of YTM returns based on the maturity (year) of bonds (with the same level of risk).

You expect a positive slope curve because the longer the term, the longer the bondholders are exposed to greater risks. For this reason, bond issuers will pay more (higher yield) to compensate investors for the risk associated with longer maturities.

An inverted curve is generally atypical, indicating that by extending maturities, investors are taking more risks for lower returns. This indicates a deterioration of the economic situation.

The shape of the yield curve changes daily with changes in yield due to fluctuations in the interest rate market. You can then decide whether you want to invest in long-term or short-term bonds, depending on the shape of the yield curve.

The process of buying bonds

The bonds are quoted by hundreds but negotiated by thousands. An estimate of $ 86 bond means that the bond is traded not at $ 86.75, but at $ 867.50 per bond. The price offered is the highest price that a buyer would pay for a bond. For example, when someone sells a bond with a market price of 94 ½, the highest point that a buyer would propose would be $ 945.00 per bond. The seller price is the lowest price offered for a bond purchased by the seller. For example, an investor who buys a bond with a 94 ½ bid and a $ 94.5 / 5 seller price would pay the $ 946.25 bond (the lowest price a seller of this bond will accept).

The spread is the difference between the bid price and the sell price of the bond, which in part represents a commission payable to the broker. A large gap indicates a negotiated bond inactive. The bonds are bought in the same way as the shares.

Although a large portion of bonds is bought and sold through brokerage companies, certain bonds can be purchased through banks or directly from issuers.

The different types of purchase orders (market orders and limit orders) used to purchase shares also apply to the purchase of bonds.

Note that it can be difficult to find current prices for offers and offers of a bond because the bond market is a broker market on which the same bonds can be offered at different prices. For example, a dealership is proposing a General Motors bond whose term is 2028 at a price of $ 867.50 and another dealer is asking for $ 900 for the same bond.

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