Common Mistakes in the Bond Valuation Process | Finance
By: Gerald Hanks
Bond valuation is a method that investors use to calculate the fair market value of a specific bond issue. This method involves determining the present value of interest payments related to the bond and the total value of the bond at its maturity date, an amount called the face value of the bond. The bond valuation process allows investors to decide whether the bond’s overall yield is worth the time and income necessary to acquire that bond and hold it until the maturity date.
The bond valuation process examines both the cash flows the bond generates from its interest payments and the face value at which the bond can be sold on its maturity date. Interest payments can come from either a fixed rate bond or a floating rate bond. The valuation process becomes more complicated for a floating rate bond because the interest payments are tied to the bond’s interest rate at the time of payment. Most investors consider paying interest a worst-case scenario when calculating the value of a bond.
Ease of sale
One of the major mistakes investors make in the valuation process is assessing the difficulty of selling the bond at maturity. Unlike stocks, which are bought and sold daily in an open market, some bonds are very difficult to sell. While long-term bonds can generate reliable income from their interest payments, buyers willing to buy bonds during their term may not be available and the seller may be forced to hold the bond until such time. that he can find a suitable buyer.
The investor should also assess the risk of default when determining the valuation of a bond. While Federal Treasury bonds present an extremely low risk of default, some corporate bonds, including “junk bonds”, carry high risks as well as their high rates of return. If the bond issuer defaults on the bond, the bond holder will no longer earn any interest income from that bond and will not be able to cash it when due.
If the bond issuer files for bankruptcy, bondholders receive their compensation after the company’s creditors, but before its shareholders. Bondholders generally do not receive the full value of the bonds when a company goes bankrupt. Instead, they receive a fraction, known as the payback ratio, of the face value of the bond. A mistake many investors make when valuing bonds is overestimating the payback rate. Experienced investors assess the requirements that a company’s creditors will have before proceeding with bond valuations and estimating their expected recovery rate.
Biography of the writer
Living in Houston, Gerald Hanks has been a writer since 2008. He has contributed to several national trade publications. Prior to starting his writing career, Gerald was a web programmer and database developer for 12 years.