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.
What is the best method of bond evaluation? ›
One of the most common methods to value a financial asset is to discount all its future cash flows to the present and sum them up. Therefore, the bond can also be calculated as the discounted present value of all the future cash flows.
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 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 assess the value of a bond? ›
How to Calculate Bond Valuation
- Step 1: Determine the cash flow and remaining payments. ...
- Step 2: Determine a realistic discount rate. ...
- Step 3: Calculate the present value of the remaining payments. ...
- Step 4: Sum all future cash flows.
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 are bonds evaluated? ›
Bond valuation is a way to determine the theoretical fair value (or par value) of a particular bond. It involves calculating the present value of a bond's expected future coupon payments, or cash flow, and the bond's value upon maturity, or face value.
What does YTM mean in bonds? ›
Yield to maturity (YTM) is the overall interest rate earned by an investor who buys a bond at the market price and holds it until maturity.
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 three major bond ratings? ›
There are 3 main ratings agencies that evaluate the creditworthiness of bonds: Moody's, Standard & Poor's, and Fitch.
The cost of a performance surety bond can vary by the type of bond and the client, but a good rule of thumb is that it costs one to three percent (1-3%) of the contractual amount. The cost of a performance bond may go up by 1.5% to 2% on riskier contracts, or down even lower if your financial rating is stellar.
What does 10% performance bond mean? ›
Performance Bonds / Contract Bonds are a type of Surety Bond and are written promises to pay for direct loss or damage suffered by a third party as a result of a breach of contract and are typically issued for 10% of the contract value.
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 are the 3 ways a bond is valued? ›
A bond's price is determined on the open market based on three major factors: its term to maturity, credit quality, and supply and demand. Term to maturity can be a bit tricky because a bond may be callable.
What is the formula for bond valuation? ›
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) + … + (C / (1 + r)^n) + (F / (1 + r)^n)Where: C = coupon payment.
How to evaluate bond funds? ›
Interest rates, credit events, geopolitical risk, and liquidity issues are all of interest to investors of bond funds. Investors should also be cognizant of the fees and potential taxable events generated by owning an actively managed bond portfolio.
What is the best way to determine bond type? ›
One way to predict the type of bond that forms between two elements is to consider whether each element is a metal or nonmetal. In general, covalent bonds form between nonmetals, ionic bonds form between metals and nonmetals, and metallic bonds form between metals.
What type of bond rating is the best? ›
Either way, bond ratings are scaled differently depending on the rating agency, and it's important to know the similarities and differences across rating firms. For Standard & Poor's, AAA is the best rating, followed by AA, A, BBB, BB, B, CCC, CC, and C.
What is the best measure of return for a bond? ›
There are two main measures of return on bonds: the current yield and the yield to maturity. The current yield, also known as interest yield or flat yield, is computed as the annual coupon payment divided by the market price of the bond.
What is the effective interest method of a bond? ›
The effective interest method is used to discount, or write off, a bond. The amount of the bond discount is amortized to interest expense over the bond's life. As a bond's book value increases, the amount of interest expense increases.
