Bonds are debt obligations. When a company or government issues bonds, it is borrowing money from bondholders. The money they raise is essentially lent to them by the buyers of the bonds; the borrower has to pay interest on these bonds or IOUs at regular intervals. However, the owners of the bonds can sell them or use them as collateral for another layer of securities. Let’s look at the factors that determine bond valuation.
The interest rate of the bond is called its yield or coupon. Bonds with higher interest payments are considered worth more than those that pay less just as two pieces of similar rental real estate where one tenant pays more for the property is considered more valuable. Some bonds pay out at maturity; these bonds have a value based on the present value of that pay-out, which is still determined by current interest rates relative to what the bond pays out. The interest rate of the bonds themselves is not the only factor in determining the value of the bonds. The prevailing interest rate is also a factor. After all, a bond that pays 5% when inflation is 6% is costing you money. A bond that pays 4% while inflation is 4% is a break-even proposition if you don’t have to pay taxes on that 4% return.
The risk associated with the bond is a factor in its valuation. If you’re afraid the company will go bankrupt and default on its bonds, the value of the bonds goes down. A solid company with years of strong financial returns has a good valuation, because it is seen as a safer investment. The valuation of bonds is also driven by the perceived risk of the stock market. When the stock market is declining in value, the valuation of bonds goes up because investors are fleeing to the seemingly safer bonds. They’ll sometimes buy bonds that otherwise seem illogical, such as buying bonds that barely earn more than the rate of inflation, because it at least yields something positive over the gradual erosion of the value of money just sitting in a bank account.
The valuation of bonds can be affected by tax policy. When state, city and local government bonds are exempted from taxes, the value of these bonds rises because you keep more of the interest payments. For example, a bond with a 6% interest rate taxed at 33% is really paying 4%.
When you buy corporate bonds, you’re typically paying a higher tax rate on the interest income than when you’re receiving payments from bonds the government gives tax preference to. Fears that the income taxes due on bonds will go up will also drive down the value of corporate bonds. These issues should be addressed as part of an online MBA degree program and most AACSB online MBAs have modules dedicated to taxation.
Bond valuation is based first and foremost on the interest rate paid by the issuing company relative to the current inflation rate. The perceived risk of the bonds compared to other alternatives affects bond prices; when the stock market is tanking, bonds go up in value. Tax treatment of interest income also affects the valuation of bonds.