What Is Above Par?
Above par is a term used to describe the price of a bond when it is trading above its face value. A bond usually trades at above par when its income distributions are higher than those of other bonds currently available in the market. This occurs when interest rates have declined so that newly-issued bonds carry lower coupon rates.
Above Par Explained
There is an inverse relationship between bond yields and prices. When yields drop due to declining interest rates in the economy, bond prices increase. Conversely, when interest rates rise, bond prices will decline, assuming no negative convexity. The basic reason for the inverse relationship is that an existing yield of a bond must match the yield of a new bond issued in a market with higher or lower prevailing interest rates. Suppose a bond is issued at par value of $1,000 carrying a coupon rate of 5%. Six months later, due to a slowdown in the economy, interest rates are lower. The bond will trade above par because of the inverse relationship between yield and price. An investor who buys a bond trading above par receives higher interest payments because the coupon rate was set in a market of higher prevailing interest rates. If the bond is taxable, the investor may elect to amortize the bond premium to offset taxable interest income; if the bond produces tax-exempt interest, the investor must amortize the premium in accordance with IRS rules.
How Far Above Par?
The movement above par for a noncallable bond depends on the bond's duration. The greater the duration, the greater the sensitivity to changes in interest rates. For example, a bond with a duration of 8 years will increase approximately 8% in price if yields drop by 100 basis points, or 1%. For a callable bond, however, the increase in price above par is limited because the bond will very likely be redeemed by the issuer when interest rates fall. That issuer would call away those old bonds and reissue new bonds with lower coupons.