Bond Valuation: How to Price Fixed Income Securities

Bond valuation is one of the most fundamental skills in fixed income — yet many finance professionals outside treasury and investment management have a shaky grasp of how bond prices actually work. This guide cuts through the theory to explain what drives bond prices, why they move inversely with yields, and how duration translates yield changes into price changes.

Basic Bond Pricing

The price of a bond is the present value of all future cash flows — coupon payments plus face value at maturity — discounted at the required yield. When the coupon rate equals the required yield, the bond prices at par (100). When required yield rises above the coupon, the bond prices below par (at a discount) — you pay less to receive the same fixed coupons. When required yield falls below the coupon, the bond prices above par (at a premium).

Yield Measures

Yield to maturity (YTM) is the single discount rate that equates the bond's price to the PV of its cash flows. It assumes the bond is held to maturity and all coupons are reinvested at the YTM — an approximation, but the standard metric for comparing bonds. Current yield (annual coupon / price) is simpler but ignores capital gain or loss and reinvestment income. Yield to call applies to callable bonds and uses the first call date as the assumed redemption date.

Duration and Interest Rate Risk

Duration measures a bond's price sensitivity to yield changes. A bond with modified duration of 7 will fall approximately 7% in price if yields rise by 1%. Longer maturity and lower coupon both increase duration — and therefore interest rate risk. Convexity refines this: the actual price change is asymmetric (bonds rise more when yields fall than they fall when yields rise), and higher convexity is better for the investor.

Credit Spreads and Default Risk

The credit spread is the yield premium a bond pays above the risk-free rate to compensate for default risk. Investment-grade bonds (BBB/Baa and above) carry modest spreads; high-yield bonds (BB/Ba and below) carry significantly wider spreads. Credit ratings from Moody's, S&P, and Fitch provide standardised creditworthiness assessments — but spreads can move significantly ahead of rating changes.

Further Reading

• Capital Structure Theory
• Cost of Debt
• Financial Management CPD

Study with Learnsignal: Financial management CPD for qualified accountants. Browse CPD.