Explanation of the bond valuation

How much should you be willing to pay for a bond?

The value of a bond is based on the future cash flows you will get from owning the bond. Where do future cash flows come from? They come from 1) coupon payments that represent cash earnings for the bondholder, and 2) repayment of principal (“face value” of the bond).

Using the bond valuation formula and assuming a 5% interest rate from a bank, a bond with a face value of $ 1,000 and a coupon rate of 4% that would allow you to earn $ 4 per year for 7 more years will give you would allow to recover the face value of $ 1,000 The value after 7 years would actually have a fair value of $ 941 … which is clearly lower than the face value of $ 1,000. So even if the face value is $ 1,000, you should be willing to pay a maximum of just $ 941 for this bond.

(The formula is a bit complicated and takes into account many factors, such as yield or yield to maturity, time remaining to maturity, and other variables. Normally, you do not need to do the calculations yourself if you are not in school. There are tons of free calculators online.)

What does the above $ 941 mean? If you pay more than $ 941 for this bonus, you would be better off depositing your money in the bank. In other words, if you pay more than $ 941, your rate of return for investing in this bond will be less than the 5% bank interest rate. So … it would be better to deposit in the bank.

So when a bond is bought or sold, is it bought or sold at face value or fair value?

Normally, if it is the first time that the issuing company issues and sells a bond in the primary bond market, it is done at face value. However, in the secondary market, when the bond is bought / sold by individuals, it is bought and sold at market value, which is often different from both the face value and the fair value. Market value is simply what real people are willing to pay or offer for the bond, even if it is less than or greater than the face value and / or the fair value. However, the market value is usually closer to fair value than to face value. However, keep in mind that in the secondary market, a huge factor affecting the price of bonds is the risk represented by your credit rating, and this factor is not included in the Bond Valuation Formula discussed above.