DEFINITION of Below Par
Below par is a term describing a bond whose market price is below its face value or principal value, usually $1,000. As bond prices are quoted as a percentage of face value, a price below par would typically be anything less than 100.
BREAKING DOWN Below Par
A bond can be traded at par, above par, or below par. A bond trading at par value is simply one that is trading at the face value of the bond’s certificate. An investor who purchases this bond will be repaid the par value at maturity, nothing more, nothing less. A bond with a price above par is called a premium bond. 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 – this value is less than what the bond was purchased for.
A bond trading below par is the same as a bond trading at a discount. As the discount bond approaches maturity, its value increases and slowly converges towards par over its term life. At maturity, the bondholder receives the par value of the bond – this value is higher than what the bond was purchased for. For example, a bond has a $1,000 face value printed on its certificate but is selling in the market for $920. This bond is said to be trading below par. Although the investor paid $920 to acquire the bond, s/he will receive $1,000 when it matures.
A bond may trade below par when interest rates change in the market. Given that an inverse relationship exists between bond prices and interest rates, if prevailing interest rates rise in the economy, the value of a bond will decrease. This is because the coupon rate on the bond is now lower than the market interest rate. In other words, investors are receiving less interest income than what they would receive if they purchase newer issues in the market. 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 couple of months later, forces in the economy raise the price of interest rates to 4.1%. Since the coupon rate on the bond is fixed at 3.5%, it is now lower than the interest rate in the economy. When a bond trades below par, its current yield (coupon payment divided by market price) is higher than its fixed coupon rate.
A bond may also trade below par if its credit rating is downgraded. This reduces the confidence level in the issuer’s financial health, causing the value of the bonds to drop below par. A rating agency downgrades an issuer’s credit after taking certain factors into consideration including concerns about the issuer’s risk of default, deteriorating business conditions, weaker economic growth, falling cash balances on the balance sheet, etc.
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 bonds issued in the current time. 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.