What Is Below Par?
Below par is a term describing a bond whose market price is trading below its face value or principal value, usually $1,000. Bonds are debt instruments that are usually issued by corporations and governments to raise money. When an investor purchases a bond, the price paid for it is called the face value. If the bond is selling for below par, its price is selling for less than its face value. As bond prices are quoted as a percentage of face value, a price below par would typically be anything less than 100.
- Below par refers to a bond price that is currently below its face value.
- Below par bonds are said to be trading at a discount, and the price will be quoted below 100.
- Bonds trade below par as interest rates rise, as the issuer's credit rating falls, or when the bond's supply greatly exceeds demand.
Understanding Below Par
A bond can be traded at par, above par, or below par. A bond trading at par means the bond is trading at the bond certificate's face value. An investor who purchases this bond will be repaid the par value at maturity and may periodically receive interest payments over the life of the bond. In other words, the maturity date of the bond is when the principal or original amount that was invested is returned to the investor.
A bond with a price above par is called a premium bond. However, the bond value will slowly decrease over the life of the bond until it is at par on the maturity date. The bondholder will receive the par value of the bond when it matures, which is less than what the bond was purchased for by the investor.
A bond trading below par means the bond is trading at a discount. As the discount bond approaches maturity, its value increases and slowly converges towards par over its life. At maturity, the bondholder receives the par value of the bond, which is a higher value than what the bond was purchased for by the investor.
If a bond, for example, has a $1,000 face value printed on its certificate but is selling in the market for $920, it is said to be trading below par. Although the investor paid $920 to acquire the bond, $1,000 will be paid to the investor when it matures.
Why Bonds Trade Below Par
A bond can trade at below par for a few reasons, which can include market conditions and changes in the company or entity that has issued the bond.
Change in Interest Rates
A bond may trade below par when interest rates change in the market. There is an inverse relationship that exists between bond prices and interest rates. If prevailing interest rates rise in the economy, the value or price of a bond will decrease. This is because the coupon rate—which is a fixed interest rate—on the bond is now lower than the market interest rate. As a result, market participants will typically sell their existing fixed-rate bonds in a rising-rate environment and opt for newly-issued bonds at the current, higher coupon rates.
For example, let’s assume a bond was issued at par. The coupon rate on the bond is 3.5%, and the market interest rate is also 3.5%. A few months later, forces within the economy push interest rates higher, and comparable bonds now offer a 4.0% rate. Since the coupon rate on the existing bond is fixed at 3.5%, it is now lower than the interest rate that could be earned by buying a new bond. When a bond trades below par, its current yield (coupon payment divided by market price) is higher than its fixed coupon rate.
Change in Credit Rating
A bond may also trade below par if its credit rating is downgraded. A rating agency measures a bond issuer's creditworthiness by examining the financial performance and stability of the issuer. A credit agency, such as Moody's Corporation (MCO), might downgrade an issuer’s credit after taking certain factors into consideration, including concerns about the issuer’s risk of default—or nonpayment of the principal back to the investors. Other factors that could lead to a credit downgrade might include deteriorating business conditions, weaker economic growth, and excessive amounts of debt on a company's balance sheet. A downgrade would reduce the confidence level in the issuer’s financial health, which would likely cause the value of the bonds to drop below par.
Supply and Demand
When there is an excess supply of a bond, the bond will trade below par. If interest rates are expected to increase in the future, the bond market may experience an increase in the number of new bonds being issued. Since bond issuers attempt to borrow funds from investors at the lowest cost of financing possible, they will increase the supply of these low interest-bearing bonds, knowing that bonds issued in the future may be financed at a higher interest rate. The excess supply will, in turn, push down the price for bonds below par.