Above Par (Bond Price) - Explained
What is Above Par?
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Table of ContentsWhat is Above Par Bond Price?When does a Bond Sell Above Par?Academic Research on Above Par Price of Bonds
What is Above Par Bond Price?
Above par is the term used to describe the price of a bond that is trading at a premium above its face value. It happens when the income distributions of a bond are above those of others available in the market. It is caused by declined interest rates which lead newly issued bonds to experience lower coupon rates.
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When does a Bond Sell Above Par?
The correlation between bond yields and prices is inverse. This means that in an economy, when declining interest rates leads to a drop in yields, the prices of bonds increase. Also, when interest rates in the economy increase, the prices of bonds conversely decrease as long as there is no negative bulge. The reason behind this inverse relationship is that the yield of a bond already existing is supposed to match that of a newly issued one, with either higher or lower current interest rates. For example, assume that a bond is issued with a face value of $1000 and a coupon rate of 5%. After six months the economy slows down, and this leads to a decline in the interest rates. Due to the opposite relationship between its yield and price, the bond will trade above its face value. Investors who purchase bonds that trade above face value enjoy higher interest payments. This is because the coupon rates were set in a market experiencing higher interest rates. In the situation where the bond is taxable, the investor may offset the taxable interest income by amortizing the bond premium. Where the bond produces tax-exempt interest, the investor is required to write off the premium according to the IRS rules gradually. The bond's duration determines the movement above par for a non-redeemable bond. The higher the period, the greater the responsiveness to interest rate changes. For example, a bond which has a span of 10 years will experience a 10% increase in its prices, should the yield drop by 1% or 100 basis points. For redeemable bonds, however, their likeliness of being redeemed when the interest rates decline limits their increase in price above par. This is because the issuer of the bonds will recall those bonds, and issue new ones that will have lower coupon rates.