In valuing bonds, it is important to first understand the differences in the type of issuances. There are essentially four types of bonds; corporate, treasury, municipal and agency.
A corporate bond is a form of debt issued by a company that can be used for a variety of purposes. Usually, corporate debt is associated with reducing leverage, research and development costs, and expansion or stock buy back initiatives. The duration or term of the bond can vary from as little as a month to as long as 50 years.
Treasury bills, notes and bonds are issued by the United States government and backed by its full faith. They are considered the safest of all investments and draw investors from all over the world. The Chinese government is the single largest holder of US government debt. Treasury bills are issued for terms less than a year, notes are issued in terms of 2, 3, 5 and 10 years and bonds are issued for a term 30 years,
Municipal bonds are debt instruments issued by states and municipalities generally for infrastructure improvements. They are backed by the full faith of the issuing authority whose strength varies from region to region. Municipal bonds carry the added incentives of being free of federal taxes and if purchased by a resident of the issuing state, free of state tax as well unless otherwise stated.
Agency bonds are issued by organizations such and Fannie Mae and Freddie Mac who provide mortgage loans in the secondary market. For a long time, these privately held firms had the implied backing of the US government. However, with the housing crisis of 2008, these quasi government agencies were absorbed by the government. As such, many believe an investment in an agency bond is nearly as safe as an investment in treasuries.
Understanding the value of a bond hinges on several factors. Bond values are quoted on a daily basis. Providing a bond broker with a CUSIP, which is a bond identification number, will allow them to give you a current bond quote. Since bonds are typically redeemed at $100 per bond, which is known a “par” value, the current price will be trading at a premium (above $100) or at a discount (below $100) relative to par. Bonds also carry a set interest rate or “coupon” which pays the investor interest on the bond. This interest rate can fluctuate based on the current price of the bond. The higher the price of the bond, the lower the yield and of course the opposite is true as well.
The current value of a bond is dependent on many factors. Corporate bonds depend heavily on rating agencies to determine their value. These independent organizations, primarily S&P and Fitch, rate the vast majority of all bonds in the U.S. They both employ a similar declining scale which starts with the safest bonds such as US treasuries, moves through various levels of investment grade bonds, and ends with different levels of speculative bonds. The value of a bond is greatly affected by its rating. All bonds are periodically evaluated by the rating agencies and upgraded or downgraded depending on any material change in the issuer’s financial condition.
This is why US treasuries typically have the lowest yield. They are always rated at the highest investment grade level the rating agencies offer. As such, the chance of default is virtually non existent. As the default probability rises, the agencies assign a lower rating to the bond and thus the issuer must lower the price and raise the interest rate yield.
The state of the economy is also a significant factor in the value of a bond. In an inflationary environment, investors expect a higher yield which will result in a lower price for the bond. When inflation is tame, or even deflationary, yields will plummet and the price of the bonds will rise substantially.
Finally, the term of the bond affects the value as well. Longer term bonds generally carry a higher yield because the risk is considered higher. Another factor included in the term is whether the bond is “callable.” That means the issuer can buy back the bond, typically at par or higher, before the term expires. Callable bonds are generally valued lower than non callable bonds.