The process of determining a corporate bond’s fair value based on the present value of the bond’s coupon payments and the repayment of the principal
Published April 3, 2020
Updated June 28, 2023
Corporate bond valuation is the process of determining a corporate bond’s fair value based on the present value of the bond’s coupon payments and the repayment of the principal. Corporate bond valuation also accounts for the probability of the bond defaulting and not paying back the principal in full.
What are Corporate Bonds?
Corporate bonds are bonds issued by corporations to finance various activities, including operations, expansion, or M&A. Corporate bonds generally offer higher yields than government bonds because they usually come with a higher probability of default, making them riskier. Additionally, there are different types of corporate bonds that range in levels of risk and yield.
The valuation of corporate bonds is similar to that of any risky asset; it is dependent on the present value of future expected cash flows, discounted at a risk-adjusted rate (similar to a DCF). However, the probability of default for the bond and the payout ratio if the bond defaults (ratio of face value received if bond defaults) must be factored into the valuation.
How to Value a Corporate Bond (Probability Tree Method)
A common way to visualize the valuation of corporate bonds is through a probability tree.
Consider the following example of a corporate bond:
- 3-year maturity
- $1,000 face value
- 5% coupon rate ($50 coupon payments paid annually)
- 60 payout ratio ($600 default payout)
- 10 probability of default
- 5% risk-adjusted discount rate
The first step in valuing the bond is to find the expected value at each period. It is done by adding the product of the default payout and the probability of default (P) with the product of the promised payment (coupon payments and repayment of principal) and the probability of not defaulting (1-P).
After the expected values are calculated, they are discounted back to period 0 at a risk-adjusted discount rate (d) to calculate the bond’s price.
Where:
- d = risk-adjusted discount rate
Corporate Bond’s Yield
Corporate bonds tend to yield more than government bonds. The reason is that they carry more default risk. For a safe government bond, such as U.S. Treasury Bills, the yield is comprised of the Federal Fund’s rate, an interest rate risk premium, and an inflation risk premium. However, for a corporate bond, investors also demand compensation for the risk of the corporation defaulting.
Some government bonds come offer default premiums; however, a U.S. treasury typically does not. Thus, a corporate bond’s yield also accounts for the default risk of the company. It is important to understand why the “tree method” to find a corporate bond’s price includes a calculation for the risk of the bond defaulting.
How to Calculate a Corporate Bond’s Yield
After calculating the corporate bond’s price through the “tree method,” a final step can be taken to calculate the bond’s yield. To calculate the yield, set the bond’s price equal to the promised payments of the bond (coupon payments), divide it by one plus a rate, and solve for the rate. The rate will be the yield.
An alternative way to solve a bond’s yield is by using the “Rate” function in Excel. Five inputs are needed to use the “Rate” function; time left until the bond matures in terms of the coupon payment periodicity (i.e., if coupons are paid annually, how many years until the bond matures), the value of the coupon payment, the price of the bond (as calculated with the “tree method”), the face value of the bond, and whether coupon payments are made at the beginning or end of a period.
More Resources
Thank you for reading CFI’s guide to Corporate Bond Valuation. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
FAQs
The valuation of corporate bonds is similar to that of any risky asset; it is dependent on the present value of future expected cash flows, discounted at a risk-adjusted rate (similar to a DCF).
What is 3 step valuation process of bond valuation? ›
Three-Step Valuation Process
The process is as follows: Forecast all cash flows which that asset/security is expected to generate over its lifetime. Determine an appropriate discount rate. Solve for the present value of the expected cash flows in step one given the discount rate from step two.
How do you calculate bond valuation? ›
The bond valuation formula can be represented as: Price = ( Coupon × 1 − ( 1 + r ) − n r ) + Par Value ( 1 + r ) n . The bond value formula can be broken into two parts for better understanding. The first part is the present value of the coupons, and the second part is the discounted value of the par value.
What is the present value of a corporate bond? ›
The present value of a bond is calculated by discounting the bond's future cash payments by the current market interest rate. In other words, the present value of a bond is the total of: The present value of the semiannual interest payments, PLUS. The present value of the principal payment on the date the bond matures.
How do you calculate the fair value of a bond? ›
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 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.
What are three ways for valuing corporate and government bonds? ›
Common bond valuation methods include the discounted cash flow (DCF) method, yield to maturity (YTM) method, credit spread analysis, bond benchmarking, and option-adjusted spread (OAS) method.
How much is a $100 savings bond worth after 20 years? ›
How to get the most value from your savings bonds
| Face Value | Purchase Amount | 20-Year Value (Purchased May 2000) |
|---|
| $50 Bond | $100 | $109.52 |
| $100 Bond | $200 | $219.04 |
| $500 Bond | $400 | $547.60 |
| $1,000 Bond | $800 | $1,095.20 |
The three main components of the Bond Valuation Formula are Coupon Payments (C), Face Value (F), and Time to Maturity (n).
Can corporate bonds lose value? ›
A decline in the issuer's rating: If a ratings firm downgrades a company, its bonds may decline in value. The company's business declines: If investors think a company may have trouble paying its debts due to a declining business, they may push its bond prices lower.
A bond's term to maturity is the length of time during which the owner will receive interest payments on the investment. When the bond reaches maturity the principal is repaid.
How are corporate bonds sold? ›
Bonds can be bought and sold in the “secondary market” after they are issued. While some bonds are traded publicly through exchanges, most trade over-the-counter between large broker-dealers acting on their clients' or their own behalf.
What is a corporate bond's yield to maturity? ›
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.
What is the difference between fair value and market value? ›
Fair value is most often used to gauge the true worth of an asset by looking at factors like its potential for growth or the cost to replace it. Market value is the observed and actual value for which an asset or liability is exchanged.
What is the three step valuation process? ›
The three-step valuation process, consisting of economy analysis, industry analysis, and company analysis, provides a structured and evidence-based approach to assessing investments and businesses.
What are the steps in the valuation process? ›
Valuation Steps:
- Define the problem. Identify the realty. ...
- Plan the Appraisal. Identify pertinent demand and supply factors. ...
- Data Collection. General Data - regional, local. ...
- Highest and Best Use Analysis. ...
- Application of the Three Approaches. ...
- Reconciliation of Value Indications and Final Value Estimate.
- Report of Defined Value.
There are several methods: net asset, earnings per share, price-to-earnings ratio, dividend discount model, discounted cash flow, and comparable company analysis. Each assesses the company's value by considering factors like assets, earnings, dividends, and industry comparisons.
What are the three primary procedures of firm valuation? ›
The three widely used valuation methods used in business valuation include the Asset Approach, the Market Approach, and the Income Approach. The three approaches vary in the way they conclude to value, but the goal of each approach is still the same: to assess the value of the operating entity (i.e., the business).
