Bond valuation is the way to determine if a bond is fair value, over-valued or under-valued. It involves calculating the present value of the future coupon payments and the value of the bond on maturity.
As a bond’s par value and interest payments are set, bond valuation helps investors to calculate what rate of return would be necessary to make a bond investment worthwhile.
To calculate the value of a bond, you firstly need to calculate the present value of all of the coupon payments.
The formula would be: (Cash flow n ÷ (1 + yield to redemption) ^ n)
You do this calculation for all coupon payments and add the figures together. The n stands for the period of time.
You then need to calculate the present value of the future value of the bond on maturity.
The formula would be: face value of the bond ÷ (1 + yield to redemption) ^ time to maturity.
To find the value of the bond, you then add the future value of the bond with the future value of all the coupon payments.
If it is below the current price of the bond, then you shouldn’t buy it. If it is higher than the current price of the bond, then you should buy the bond.
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