When evaluating the potential performance of a bond, investors need to review certain variables. The most important aspects are the bond's price, its interest rate and yield, its date to maturity, and its redemption features. Analyzing these key components allows you to determine whether a bond is an appropriate investment.
key takeaways
- There are four key variables to be considered when evaluating a bond's potential performance.
- The bond's current price vis-a-vis its face value is one.
- The bond's maturity (the number of years or months the issuer is borrowing money for) is another variable.
- The bond's interest rate and its yield—its effective return, based on its price and face value—is a third factor.
- A final factor is redemption—whether the issuer can call the bond back in before its maturity date.
Price
The first consideration is the price of the bond. The yield that you will receive on the bond impacts the pricing.
Bonds trade at a premium, at a discount or at par. If a bond is trading at a premium to its face value, then it usually means the prevailing interest rates are lower than the rate the bond is paying. Hence, the bond trades at a higher amount than its face value, since you are entitled to a higher interest rate than you could get from comparable instruments.
A bond is trading at a discount if the price is lower than its face value. This indicates the bond is paying a lower interest rate than the prevailing interest rate in the market. Since you can obtain a higher interest rate easily by investing in other fixed income securities, there is less demand for a bond with a lower interest rate.
A bond with a price at par is trading at its face value—the amount at which the issuer will redeem the bond at maturity. This is also called the par value.
Interest Rate and Yield
A bond pays a certain rate of interest at periodic intervals until it matures. An investor can use cumulative interest to calculate a bond's performance by summing the interest paid over a set period. However, there are other more comprehensive methods, such as effective annual yield.
Bonds' interest rates, also known as the coupon rate, can be fixed, floating, or only payable at maturity. The most common interest rate is a fixed rate until maturity; it's based on the bond’s face value. Some issuers sell floating rate bonds that reset the interest based on a benchmark such as Treasury bills or LIBOR.
As their name implies, zero-coupon bonds don't pay any interest at all. Rather, they are sold at steep discounts to their face values. This discount reflects the aggregate sum of all the interest the bond would've paid until maturity.
Closely related to a bond's interest rate is its yield. The yield is the effective return earned by the bond, based on the price paid for the bond and the interest it generates. Yield on bonds is generally quoted as basis points (bps).
Two types of yield calculations exist. The current yield is the annual return on the total amount paid for the bond. It is calculated by dividing the interest rate by the purchase price. The current yield does not account for the amount you will receive if you hold the bond to maturity. The yield-to-maturity (YTM) is the total amount you will receive by holding the bond until the end of its lifespan The yield to maturity allows for the comparison of different bonds with varying maturities and interest rates.
For bonds that have redemption provisions, there is the yield to call, which calculates the yield until the issuer can call the bond—that is, demand that investors surrender it, in return for a payoff.
When interest rates rise, bond prices fall. Conversely, when interest rates fall, bond prices rise.
Maturity
The maturity of a bond is the future date at which your principal will be repaid. Bonds generally have maturities of anywhere from one to 30 years. Short-term bonds have maturities of one to five years. Medium-term bonds have maturities of five to 12 years. Long-term bonds have maturities greater than 12 years.
The maturity of a bond is important when considering interest rate risk. Interest rate risk is the amount a bond’s price will rise or fall with a decrease or increase in interest rates. If a bond has a longer maturity, it also has a greater interest rate risk.
Redemption
Some bonds allow the issuer to redeem the bond prior to the date of maturity. This allows the issuer to refinance its debt if interest rates fall. A call provision allows the issuer to redeem the bond at a specific price at a date before maturity. A put provision allows you to sell it back to the issuer at a specified price prior to maturity.
A call provision often pays a higher interest rate. If you hold such a bond, you are taking on additional risk that the bond will be redeemed and you will be forced to invest your money elsewhere, probably at a lower interest rate (a decline in interest rates is usually what triggers a call provision). To compensate you for taking on this chance, the bond pays more interest.
FAQs
An investor can use cumulative interest to calculate a bond's performance by summing the interest paid over a set period. However, there are other more comprehensive methods, such as effective annual yield. Bonds' interest rates, also known as the coupon rate, can be fixed, floating, or only payable at maturity.
How to understand bond fund performance? ›
A bond fund's total return measures its overall gain or loss over a specific period of time. Total return includes income generated by the underlying bonds and (both realized and unrealized) price gains or losses. Investors should focus on total return when evaluating performance of bond funds.
What are the five elements that analysts use to determine the value of bond? ›
The key factors that influence bond valuation are the time to maturity, the coupon rate, the face value of the bond, the yield to maturity, and the current prevailing interest rates in the market.
How do you valuate bonds? ›
The discounted cash flow method is one of the most widely used methods to value a bond. In this method, the cash flows received from the bond (i.e., coupon and par value) are discounted at the market rate. Then the present value of all the cash flows is summed up to get the value of the bond.
How do you value a performance bond? ›
The cost of a performance bond is normally calculated as a percentage of the value of the contract, and with reference to the length of the period to be covered. For longer projects, there may be a slightly higher cost. A typical performance bond is normally about 10% of the contract value, but this can vary.
How do you evaluate bond ratings? ›
Based on each agency's individual set of criteria, analysts determine the entity's ability to pay their bills and remain liquid, while also taking into consideration a bond's future expectations and outlook. The agencies then declare a bond's overall rating, based on the collection of these data points.
How do you tell if a fund is performing well? ›
Many people consider total return the most accurate measure of performance. To compare the total returns of two or more funds, you use percent return, which is a fund's total return divided by your initial investment.
How to tell if a bond is overvalued or undervalued? ›
When a security's current market price is approximately equal to its value estimate, the security is considered to be fairly valued. Conversely, when the market price exceeds the value estimate, the security is overvalued, and so the security is undervalued when the market price is lower than its estimated value.
How do investors interpret bond ratings? ›
Rating agencies consider a bond issuer's financial health and ability to pay a bond's principal with interest. The rating organizations provide investors with grades, such as "AAA" or "B-" that indicate whether a bond offers more security and lower yield or is more speculative. Fidelity. "Bond Ratings."
What are the four key relationships for bond valuation? ›
We can now calculate the value of a bond using the discounted cash flow method. To do this, we need to know (1) the bond's interest payments, (2) its par value, (3) its term to maturity, and (4) the appropriate discount rate.
Beyond ratings, the quickest way to determine the safety of a company-issued bond is by looking at how much interest a company pays relative to its income. Corporate bonds generally pay higher interest than government bonds because they have a relatively higher risk of default.
What is the key factor in Analysing bonds? ›
This valuation hinges on key factors including the bond's face value, coupon rate, maturity date, and yield. The face value denotes the amount the issuer commits to repay at maturity, while the coupon rate signifies the annual interest paid to the bondholder.
What is 3 step valuation process of bond valuation? ›
Lay out the cash flows on a time line; • Step 2. Determine an appropriate discount rate (yield to maturity); • Step 3. Calculate the present value of the coupons and the par value; • Step 4. Add up the two present values to calculate the bond price.
How are bonds evaluated? ›
Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. In practice, this discount rate is often determined by reference to similar instruments, provided that such instruments exist.
What is bond valuation for beginners? ›
The bond pricing formula is used to calculate the value of a bond. It is based on the present value of the bond's future cash flows, which consist of the coupon payments and the face value of the bond. The formula is as follows:Bond Price = (C / (1 + r)^1) + (C / (1 + r)^2) + …
What is a 2% performance bond? ›
In order to get a performance bond, the contractor agrees to pay the surety a small percentage of the total bond amount, usually between 1% and 4%. In exchange, the surety promises to pay up to the agreed bond amount if the contractor fails to deliver on its obligations.
What index measures bond performance? ›
The S&P U.S. Aggregate Bond Index is designed to measure the performance of publicly issued U.S. dollar denominated investment-grade debt.
What is the formula for performance bond? ›
The following steps outline how to calculate the Performance Bond: First, determine the contract amount (C). Next, determine the percentage of the contract amount that the bond covers (P). Next, gather the formula from above = PB = (C * P) / 100.
