Definition: A bond whose market value has risen above the amount an investor loans to the company in return for receiving the bond. The loan amount goes by many names, including face value and par value, and is usually $1,000. See the definition for bond for an important introduction to bonds.Example: You bought a new bond five years ago for $1,000. Back then, because of concerns about future inflation and interest rates, companies had to offer 7% interest to get investors like you to buy them. This means that the bond pays you $1,000 * 7%, or $70 per year in interest.
If today inflation was lower than originally expected, the very same company could issue a new bond paying only 6%, or $60 per year, and still find enough investors to willingly buy them. If investors are willing to loan the company $1,000 in return for receiving $60 in interest per year, then surely the bond that you hold, which pays you $70 per year, is worth more than the new bond. If you wanted to sell it, you would get more than $1,000 for yours. It would sell for a premium.
Investeach explains: There is a quick way to estimate the current value of the 7% bond mentioned above. To do so, we take the 7% rate and divide it by the 6% rate being paid on new bonds issued by similar companies, and then we multiply that by the face value, which is usually $1,000. Therefore, the approximate value of your 7% bond is 7% / 6% * $1,000, or $1,167.
Besides a drop in interest rates since the time you bought your bond, there is another reason why a bond may sell above par. The company issuing a bond may be stronger and more stable than it was when it initially issued the bonds. This strength means that investors are taking less of a risk that the company won’t be able to make annual interest payments and pay back the loan amount at the end of the bond’s term. As a result, the value of the bond may rise above its par value (ie: sell for a premium).
Riddle me this:
1. What is the most common value of a bond?
2. What are the names we use for the initial value of a bond?
3. What will cause a bond’s value to rise above its original value?