Valuing a bond

Looking for a meatier Investor's College article? Grab a calculator and sink your teeth into this one.

Valuing a bond might seem like a strange topic for a stockmarket publication. But there are some very good lessons and analogies for share investors, so stick with us. A bond is simply a tradeable debt security. While the stockmarket is a place where investors can easily buy and sell equity, or ownership of businesses, the bond market is a place where investors buy and sell debt, or loans. Actually, more specifically, it's a market for longer-term debt, as short-term debt falls under different markets, namely the bank bill and treasury note markets.

Borrowing long-term gives borrowers the certainty that short-term funding cannot provide. On the flip side, however, many lenders have little interest in actually locking up their money for very long periods—and this creates an imbalance. A bond solves that problem by giving the borrower long-term funding whilst giving the lender the flexibility of a security that can be sold at short notice—although it could be for a big profit or loss depending on how interest rates have moved.

Let's look at an example of a bond with three years left to run. It was issued as a 10-year bond exactly seven years ago, in a time of higher interest rates, and therefore carries annual 'coupons'—or interest payments from the borrower—totalling 10% per annum. While most bonds are semi-annual, or pay coupons twice a year, for simplicity we've assumed this bond pays one annual 10% coupon, or $10 a year on its $100 face value.

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