Bond valuation happens to be one of the most misunderstood aspects of bonds. When we talk about bond valuation, we are not just concerned with the coupon payment. That is because a bond may be issued below par value, at par or above par. So the value of a bond consists of 2 parts, the value of all the future coupon payments and the difference between the purchase/issue price and maturity value (normally denominated in $1000).

 

Bonds tend to be valued using yields, which basically mean how much returns you would get on your investment per year. In a way, it is quite similar to comparing to dividend yields from a stock except that the stock has potential capital appreciation/loss as well. There are a few yield calculations, such as nominal yield, current yield, yield to maturity and yield to call.

 

 

Nominal Yield = Annual Coupon Payment / Face Value

 

 

Current Yield = Annual Coupon Payment / Current Bond Price

 

 

This is the most important yield calculation as it takes into account the time value of money, coupon payments and difference between the current bond price and future value. The actual formula for bond YTM calculation is very complicated, fortunately there is an easier way. The easiest way to calculate bond YTM is using a bond calculator. Bond calculators can be found online, on excel or financial calculators such as the BA II+.

 

Excel:

 

There is a yield function in excel, you just type in the cell

=YIELD(settlement, maturity, rate, pr, redemption, frequency, [basis])

For example (Taken from Excel Help),

Your yearly return from the bond investment above will be 6.5%.

 

 

There are certain bond issues known as callable bonds which the issuer has the right  to recall the bonds before maturity date. Basically the issuer will pay the principal in full and stop paying coupon payments. This usually happens when the bond is paying a much a higher rate than current market rates. The calculation for the returns in such case is the Yield to Call. YTC is calculated in the same way as YTM, except that the maturity date changes to the date when the call is in effect.

 

 

Now that we know how to calculate bond yield to maturity, how do we use this information to invest? Generally, if we compare YTM of several bonds, the higher the YTM, the more attractive it is. However, there are many factors which can affect the YTM, such as tenure of the bond, credit risk of the issuer, yield spreads and current market interest rates.

 

We can also compare the yield of a bond to an equity investment to assess the attractiveness of the bond in our portfolio. For example, a stock may have a dividend yield of 4%, while a corporate bond may have a yield of 3%. While the bond yield may seem less attractive, unless there is a default, the yield is pretty much guaranteed as long as you hold the bond to maturity. However, the stock may reduce dividends or increase dividends based on business performance and dividend policies. Also, the bond will return the face value at maturity while the stock may be held until you sell it at a capital gain or loss.

 

On the flip side, we can compare the bond yield to money market instruments such as fixed deposits. Fixed deposits are one of the highest almost risk free instrument, as opposed to just letting your money sit in the bank. Fixed deposit of the same tenure may give you 1.5% return, which is half of the bond yield at 3%.

 

So we know that fixed deposits are almost risk free, but yield the lowest, while bonds can yield much higher for the same period and stocks can yield even higher potential returns at higher risks. So using various combinations of assets will help you manage your risks and returns in your portfolio.

 

In Part 3 of this series, we will discuss advantages and potential risks of including bonds in your portfolio.