Below Par - Explained
What is Below Par?
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What is Below Par?
Below par is a concept used for a bond in case its market price is lower than its par or face value, that is $1000 in most of the cases. Since the price of bonds is ascertained as a specific percentage of principal value, any price that is lower than $100 would be considered as a below par.
How Does Below Par Work?
One can trade bonds at a price that is at par, above par, or below par. When a bond trades at the principal value as shown in the certificate, it is considered to be trading at par. When an investor buys bonds at par, it means that he or she would receive the only par or face value at the time of maturity. There wont be anything more or less that they'd receive. When the bond is priced above par, it is known as a premium bond. There is a significant decline in the value of the bond as it approaches the maturity stage. The person having the bond gets the bonds face value on its maturity, which tends to be lower than the purchase price of the bond. A bond that trades below par is referred to as a discounted bond. When the discounted bond starts to mature, there will be an increase in its value. And by the time it reaches the maturity stage, it will reach the par value. Here, the bondholder will receive an amount that is more than what he or she paid for at the time of purchasing the bond. For instance, the face value of a bond as given in the certificate is $1000. Now, a person buys it for $920 in the market. This will be a case of below par, or a bond trading at a discount. Even if the investor has paid $920 for buying the bond, he will be able to get $1000, that is its face value, at the time it matures. When there are fluctuations in the market interest rates, the bond is traded below par, or at a discount. There is a negative correlation between the price of bonds and interest rates. Hence, if there is an increase in interest rates in the market, there will be a decrease in the value of bonds. This is so because the bonds coupon rate is now less than the interest rate. In simpler words, investors wont receive as much interest income as they should have received, in case they buy fresh issues in the financial market. For instance, a company issues a bond at par with a coupon rate of 3.5%, and an interest rate of 3.5% as well. After a few months, the economic forces increase the price of interest rates to 4.1% with the coupon rate being constant. A bond that is trading at a discount will have its current yield more than the coupon rate whose price remains stable over time. Current yield can be calculated by dividing the coupon payment with market price. If the credit rating of a bond is not good, it will be traded at below par. This poor credit rating can leave investors with an assumption that the issuing organization doesn't have a sound financial position, therefore resulting in a decline in bonds value. A credit rating agency considers several factors such as failure to make repayments, bad economic development, poor business operations, negative impacts on the cash balances in financial statements, etc. to identify if the business has a good or bad credit rating. When the supply of bond increases in the market, it will trade at below par. If there are predictions that the interest rates are likely to rise ahead, it will lead to more bonds being issued at present. Companies or individuals issue bonds in the market to arrange easy loans at lower interest rates. So, when the interest rates will increase in the near future, there will be more supply of bonds carrying lower interest rates. This increase in supply ultimately causes the bond price to fall, below par.
Academic Research on Below Par
- Maximum duration ofbelow parbonds: a closed-form formula, Pianca, P. (2005). Maximum duration of below par bonds: a closed-form formula. The nature of the relationship between bond's duration and its term to maturity is somewhat complex and contrary to what our intuition would suggest, there is not always a direct relationship between duration and maturity, in the sense that an increase in maturity does not necessarily entail an increase in duration. For bonds selling below par, an increase in maturity has the following effects: duration first increases, it reaches a maximum and then decreases. For this maximum we provide an explicit formula based on the Lambert W function.
- Dangers of Shares without Par Value, Bonbright, J. C. (1924). Dangers of Shares without Par Value.Colum. L. Rev.,24, 449.
- Uses of Stock Having No Par Value, Hollen, R. H., & Tuthill, R. S. (1921). Uses of Stock Having No Par Value.ABAJ,7, 579.
- Treatment of discount on bonds, Little, A. S., & Caffyn, H. R. (1937). Treatment of discount on bonds.Journal of Accountancy (pre-1986),64(000003), 216.
- CDS Valuation and Trading Strategies, Oricchio, G. (2011). CDS Valuation and Trading Strategies. InCredit Treasury (pp. 212-285). Palgrave Macmillan, London. Credit default swaps and bonds of the same credit will usually trade similarly, as both reflect the markets view of default risk. As discussed, a CDS is a measure of credit risk of an entity. Credit default swaps are not measured as a spread over a benchmark, rather, the spread is the annual coupon the buyer of protection (short risk) will pay and the seller of protection will receive. Quite simply, the higher the perceived credit risk, the higher the CDS spread. In order to compare credit default swaps with bonds, one needs to isolate the spread of the bond that compensates the holder for assuming the credit risk of the issuer.