2.16.2 Valuing Fixed-Income Securities
The most well-known method of determining the value of fixed-income securities is the discounted cash flow (DCF) method. The DCF method calculates the present value of all the future cash flows of a fixed income investment. Recall that a present value is what some future amount is worth today. This amount would include every scheduled interest payment, as well as the return of the original amount invested (the principal), which is usually the face value of the security. The present value of each payment is calculated using the present value formula:
For example, if a bond is purchased today that has a $1,000 face value and is scheduled to pay $25 every six months for the next ten years, the DCF model is used to calculate the present value of each of these future payments (the semiannual payments and the principal amount due at maturity).
Once all present values of all the payments are calculated, they are combined to arrive at a total discounted cash flow for the future of the security. If this total is greater than the current price of the bond or fixed-income security, it is considered a good investment, meaning the bond should be purchased. This conclusion is based on the belief that the investor is essentially buying the right to the future cash flows of an investment at a discount to what the investment is worth when the present value is calculated. Conversely, if the discounted cash flows are less than the current price of the bond or security, this method of valuation would say that it is overpriced and should be avoided.
Example: Imagine that you are considering a bond that pays 5% each year for five years. The bond is selling at $950 and will pay $1,000 at maturity. Is it a good value? Consider the following payment structure. Imagine that interest rates have risen since the bond was issued and comparable bonds are now paying 5.5%. For the discounted cash flow method, you would use 5.5% as your di