Corporate Bond Valuation

Is the process of determining the fair value of a bond.

Corporate bond valuation is the process of determining the fair value of a bond. The process takes three inputs into consideration:

  • Present value of the bonds coupon payments 
  • Repayment of the principal value
  • The probability of the bond defaulting

Corporate Bond

The valuation of corporate bonds is dependent on the present value of future cash flows. The probability of the bond defaulting and the payout ratio from defaulting will also be used in the calculation.  

Corporate bonds carry the risk of the company defaulting. Therefore, from an investor's point of view, they are riskier when compared to government bonds. However, for that reason, corporate bonds offer higher yields than government bonds. 

For example, a government bond, such as a US Treasury Bill a very conservative investment. The yield would be calculated using the Federal Funds rate, interest and inflation risk rate, and premiums. 

Corporate bonds would be at the same rates; however, due to the risk of the corporation defaulting, they require further payment. 

What is a Corporate Bond?

Similar to any other bond, a corporate bond is a debt obligation. In this case, investors' money is borrowed by a corporation for the return of timely interest payments on the principal. When the bond matures (comes to an end), the corporation is obligated, in most cases, to return the principal.

This is very different from a stock, where the investor has a share in the company's ownership, receives dividend payments, and experiences capital appreciation/depreciation along with the company's value. 

Bonds are different as there is no ownership in the company; however, similar to dividends, the investor may receive small, periodic payments. 

Paperwork

Corporate bonds are widely used and considered one of the largest components of the U.S. bond market. 

Corporations need bonds to raise funds to purchase new equipment, research and development (R&D), stock buy-backs, dividend payments, and mergers and acquisitions (M&A).

Like all other bonds, corporate bonds are given a credit rating from an agency based on an evaluation of the risk of the company defaulting. From the rating, the bond is then given either investment-grade status or speculative-grade status. 

You can view a list of the top corporate bonds of 2022 by U.S. News here.

Deal

A corporate bond is deemed investment grade, indicating a low risk of default. Bonds deemed "AAA" (triple A) prove to be of the lowest risk. However, with low risk also comes lower returns.

On the other hand, speculative-grade bonds are the opposite, signifying a greater risk of the company defaulting. Bonds given ratings below "BBB" show the bond may be risky; however, they will offer greater interest payments. 

Any rating below "BB" (one down from "BBB") is deemed to be a junk bond.

Corporate Bond Valuation Example

The valuation of corporate bonds is easiest to understand through a visual example. A common way to structure a corporate bond is using a probability tree. 

Flow chart

To better understand how the probability tree works, let's continue with the following example:

Corporate Bond

  • 3 Year maturity
  • $100,000 Face Value
  • 3% Coupon Rate ($3,000 paid annually)
  • 50% Payout Ratio ($50,000 default payout)
  • 10% Probability of Default
  • 5% Risk-Adjusted Discount Rate

Calculations

1. Calculate the expected value (EV):

We will begin by calculating an expected value (EV) for each period of the corporate bond. The formula for each expected value will be the product of the default probability and default payout, plus the product of the coupon payment and the probability of not defaulting. The probability of default will be represented with the letter (P).

Period 1

EV1= P(Default Payout) + (1-P)(Coupon Payment)

EV1 = 0.10($50,000) + 0.90($3,000)

EV1= $7,700

Period 2

Calculating the expected value for period two will use the same formula. However, there is now the added uncertainty of (1-P) or (0.9), the chance bond of not defaulting. 

Therefore, we will multiply everything from the original formula by that probability. 

EV2 = (1-P) ( P(Default Payout) + (1-P)(Coupon Payment) )

EV2 = (0.9) (0.10($50,000) + 0.90($3,000))

EV2 = $6,930

Period 3

For period three, there is now another uncertainty of (1-P), or (0.9), that will be applied, causing the original formula to be multiplied by (1-P)2.

EV3(1-P)2( P(Default Payout) + (1-P)(Coupon Payment + Principal) )

EV3(0.9)2 (0.10($50,000) + 0.90($3,000 + 100,000))

EV3 = $79,137 

2. Discount back to present value

Now that the expected value for each period is calculated, they must be brought back to their present value (period 0) using a risk-adjusted rate (r) to derive the bond's price. In the following equation, n represents the number of periods.

Bond Price = (EV1)/ (1+r) + (EV2)/ (1+r)^2 + …….. + (EVn)/ (1+r)^n

Bond Price = (7,700)/ (1.05) + (6,930)/ (1.05)^2 + (79,137)/ (1.03)^3

Bond Price = $86,040.61

The calculated value of the corporate bond is $86,040.61. Bonds can trade at a discount or a premium depending on the current market interest rate

The bond is sold at a premium when the interest rate is lower than the bond's coupon rate.

The bond is sold at a discount if the interest rate is higher than the bond's coupon rate.

Therefore, the value of the bond may change throughout the term.

Calculations

3. Calculate the bond's yield

Once the bond price has been calculated, it is possible to find the yield. The calculation will start with setting the bond price equal to the payments divided by the interest rate plus one. 

FormulaCalculation

Now, solving for 'r', the yield of the corporate bond amounts to a yield of 4.02%.

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Researched and authored by Thomas Fallows | Linkedin

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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