Key Takeaways
- Above par refers to a bond trading above its face value, often due to a decline in interest rates.
- Bonds above par are priced higher because they offer higher yields than newly issued bonds at lower rates.
- The inverse relationship between yields and prices causes existing bonds to trade above par when rates fall.
- Bond credit rating upgrades or reduced supply can push bond prices above par.
- The price of a noncallable bond is more sensitive to rate changes than a callable bond, which can be redeemed early.
What Is Above Par?
Above par refers to a bond trading for more than its original value or face value, typically occurring when market interest rates drop. Declining interest rates or an improved credit rating of the issuer can cause a price to become above par. When interest rates in the market fall, new bonds offer lower returns. So, older bonds with higher fixed returns become more valuable, trading above their original price.
We’ll explain what it means when bonds trade above par, including the factors affecting bond prices like market interest rates and credit ratings.
Understanding the Concept of Above Par Bonds
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.
A bond may also trade above par if its credit rating is upgraded. This reduces the risk level associated with the issuer’s financial health, causing the value of the bonds to rise. A rating agency upgrades an issuer’s credit after taking certain factors into consideration, including the issuer’s risk of default, external business conditions, economic growth, and balance sheet health, among other things.
When there is a reduced supply of a bond, the bond will trade above par. If interest rates are expected to decline in the future, the bond market may experience an decrease in the number of bonds issued in the current time as issuers wait for those better rates instead. Since bond issuers attempt to borrow funds from investors at the lowest cost of financing possible, they will decrease the supply of these higher interest-bearing bonds, knowing that bonds issued in the future may be financed at a better interest rate. The reduced supply will, in turn, push up the price for bonds below par.
Factors Influencing How Much a Bond Trades 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.