One of key financial management skills is valuing bond (or debt). In basic financial management course, you are taught the concepts of discounted cash flow (DCF) in valuing different types of debts.
In ACCA Advanced Financial Management (AFM) exam, you have to understand all the key concepts deeply in bond valuation as well as yield to maturity.
Bond valuation
Bond Valuation is a technique that is used to determine the theoretical value of a given bond. It can be seen that the valuation is used in order to accurately calculate the present value of the payments that are expected to be received over the course of time.
By calculating the present value of the future interest payments that are likely to be received (or the cash flows), the actual value of the bond can be calculated. It broadly entails two parts, which are the cash flow, as well as bond’s value at maturity.
Given the fact that the bond’s par value or face value stays fixed, bond valuation is considered as a very viable tool that can help investors determine the rate of return, which would make the investment in the bond worthwhile.
Coupon Bond Valuation
Coupon Payments on bonds can either be annual, or semi-annual. This is also included in the calculation of the bond valuation, in addition to the basic parameter of the par value of the bond.
As far as Coupon Bond Valuation is concerned, it can be seen that the present value of the expected cash flow needs to be amalgamated with the present value of the bond price (the face value).
Coupon Bond Valuation is probably the most used Bond Valuation schemes, because of the fact that most bonds do offer a coupons, either on an annual, or a semi-annual basis.
Zero Coupon Valuation
On the other hand, Zero Coupon Valuation does not rely on annual or semi-annual coupon payments. On the contrary, Zero Coupon bonds are traded at a discounted price as compared to their par value when they are issued. In this case, the difference in the spread between the prices at which the bond is issued, as well as the par value is considered as the interest earned on the bond.
As far as valuation of Zero Coupon bonds are concerned, it can be seen that there is a need to find the present value of the inherent face value of the bond. The present value of the face value is subsequently calculated in order to arrive at the exact value of the bond.
Recap of Yield to Maturity (YTM)
YTM (Yield to Maturity) can be simply defined as the total return that is expected to be generated on the bond till the point of maturity of the bond itself.
It is considered as a long-term bond yield, and it is expressed as a percentage, which is an annual rate. It is alternatively referred to as the book yield, or the redemption yield.
It assumes that all coupon payments are reinvested at a yield equal to the YTM and that the bond is held to maturity.
YTM of a discount bond is simply calculated by using the following formula:
Where:
n = number of years to maturity
Face Value = bond’s maturity value or par value
Current Price = currently prevalent bond price
However, it can be seen that there are a number of issues that exist when it comes to calculating YTM. Therefore, there are numerous errors and trials that are often conducted when it comes to estimating the YTM of the bond itself.
Estimating YTM by interpolation method
Calculation of YTM is considered as a very important aspect because of the fact that it involves a number of different processes that might be complex in terms of achieving accurate results for the investors.
Given the fact that there is an inverse relationship between bond price and bond yield, it can be seen that this relationship can be used in order to calculate the Yield to Maturity. It must be seen that the reason of the inverse relationship simply means that price is low, and yield is high. YTM can be calculated using the interpolation methods using the following steps:
Firstly, it is done by ensuring that the bond price is lower than the face value. If this applies, YTM is supposed to be higher as compared to the coupon rate. Otherwise, YTM is considered lower than the coupon rate.
The second step that is undertaken is to set an arbitrary value in a manner which shows that the present value of the bond cash flows turns to be higher than the bond price itself.
Followed by this step, a higher value is set, such that the present value of the bond cash flows turns out to be lower than the bond price itself.
After these parameters have been set, the following formula is used in order to calculate the YTM:
Importance of yield to maturity
YTM can be regarded as a very important parameter that helps investors to get an idea regarding the expected payout they can expect over the course of the timeline of the bond itself. It can be quite useful for estimating whether buying a bond is a good investment. An investor will determine a required yield (the return on a bond that will make the bond worthwhile).
The main advantage of calculating YTM is the fact that it really enables investors to draw comparisons between different securities and returns. Because YTM is expressed as an annual rate regardless of the bond's term to maturity, it can be used to compare bonds that have different maturities and coupons since YTM expresses the value of different bonds in the same annual terms.
By being able to compare the alternate investment options and protocols, it can be seen that investors can easily gauge the efficacy of their investment, and if it is a viable option as compared to other existing tools. This can help them determine the securities that can be added to their portfolios.
In the same manner, having a clear idea regarding YTM can be used to gain understanding regarding how market conditions changes can impact the overall portfolio. This information can therefore be utilized in order to get a holistic idea regarding portfolio management, which can help them get an overall diversified result as a result of that particular portfolio management.
If you find this article is helpful and you want to help others too, just share it in any social media (such as Facebook, LinkedIn).