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:
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.
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.
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