Definition
Below Par refers to a situation where a security, particularly a bond, is trading at a price lower than its face value or nominal value. The face value is the amount paid to the bondholder at maturity. When a bond is bought below this value, it suggests that the bond may be offering a lower return or has higher perceived risk compared to similar securities.
Examples
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Corporate Bonds: A corporate bond with a face value of $1,000 might be trading at $950. This indicates that the market values the bond at less than its face value, possibly due to increased interest rates or perceived financial instability of the issuing corporation.
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Government Bonds: Similarly, a government bond with a face value of $1,000 might trade at $980. This can happen if newer bonds are issued with higher interest rates, making the older bond’s lower rates less attractive.
Frequently Asked Questions
Q1: Why might a bond trade below par?
- A1: Bonds can trade below par due to various factors such as rising interest rates, lower credit ratings, or overall market conditions which may affect the issuer’s ability to meet interest or principal payments.
Q2: What happens if I sell a bond that is below par?
- A2: If you sell a bond below par, you might incur a loss if the sale price is less than your purchase price. However, if the purchase price was also below par, the gain amount is treated as capital gain and taxed accordingly.
Q3: Can below par bonds result in capital gains?
- A3: Yes. If a bond purchased below par is held until maturity and redeemed at face value, the difference can result in a capital gain.
Related Terms
- Face Value: The nominal value of a bond that is paid back to the bondholder at maturity.
- Capital Gain: The profit earned from the sale of a bond or security for more than its purchase price.
- Yield: The return on investment for a bond, usually expressed as a percentage, considering both the interest income and any capital gains or losses.
- Bond: A fixed-income instrument representing a loan made by an investor to a borrower.
Online Resources
Suggested Books for Further Studies
- The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More by Annette Thau
- Bond Markets, Analysis, and Strategies by Frank J. Fabozzi
- Fixed Income Analysis by Frank J. Fabozzi and Barbara S. Peterson
Fundamentals of Below Par: Investment Basics Quiz
### What does 'below par' mean in relation to bonds?
- [ ] A bond is trading above its face value.
- [x] A bond is trading below its face value.
- [ ] A bond has matured.
- [ ] A bond has defaulted.
> **Explanation:** 'Below Par' means that the bond is trading at a price less than its face or nominal value.
### What impact do rising interest rates typically have on bond prices?
- [x] Bond prices often fall.
- [ ] Bond prices remain unchanged.
- [ ] Bond prices rise.
- [ ] Bond prices become volatile.
> **Explanation:** Rising interest rates generally lead to a decrease in bond prices because new bonds issued with higher rates make existing lower-interest bonds less attractive.
### What is the face value of a bond?
- [x] The amount paid back to the holder at maturity.
- [ ] The initial purchase price of the bond.
- [ ] The interest earned on the bond.
- [ ] The price investors are willing to pay.
> **Explanation:** The face value is the nominal amount paid back to the bondholder at maturity.
### If a bond is purchased at $900 and redeemed at $1,000, what is this difference called?
- [ ] Discount.
- [x] Capital gain.
- [ ] Yield.
- [ ] Coupon payment.
> **Explanation:** The difference of $100 is considered a capital gain, realized when the bond is redeemed for more than it was purchased.
### What does a bond trading below par indicate about market sentiment?
- [ ] Positive sentiment.
- [ ] Neutral sentiment.
- [x] Negative sentiment.
- [ ] Volatile sentiment.
> **Explanation:** A bond trading below par usually indicates negative market sentiment, possibly due to higher perceived risk or unfavorable market conditions.
### How are bonds that are trading below par normally taxed upon sale?
- [x] As capital gains if sold above purchase price but below face value.
- [ ] As ordinary income.
- [ ] As interest income.
- [ ] Not taxed at all.
> **Explanation:** If a bond purchased below par is sold higher than its purchase price but below face value, the resulting profit is typically taxed as a capital gain.
### Why could a bond being below par be attractive to investors?
- [x] Potential for capital gains.
- [ ] Because they offer higher coupon payments.
- [ ] Because they have no risk.
- [ ] Because they are short-term investments.
> **Explanation:** Bonds trading below par may offer capital gains if the bond is held until maturity or if the issuer's financial situation improves.
### Which of the following is NOT a factor that could cause a bond to trade below par?
- [ ] Rising interest rates.
- [ ] Lower credit ratings.
- [ ] Market conditions.
- [x] An increase in the bond's coupon rate.
> **Explanation:** An increase in the bond’s coupon rate makes it more attractive, potentially raising its price above par.
### What is the primary risk associated with investing in bonds trading below par?
- [ ] Price volatility.
- [ ] Inflation risk.
- [x] Credit risk.
- [ ] Liquidity risk.
> **Explanation:** Bonds that trade below par usually carry higher credit risk, which is the risk that the issuer may default on payments.
### Which entity might issue bonds that frequently trade below par?
- [ ] Local municipalities.
- [ ] High-credit-rated corporations.
- [x] Companies with lower credit ratings.
- [ ] Federal governments.
> **Explanation:** Companies with lower credit ratings are more likely to issue bonds that trade below par due to perceived higher default risk.
Thank you for exploring the concept of Below Par with us and participating in the quiz to solidify your understanding. Keep striving for excellence in your financial knowledge!
