Question

Having determined how to calculate the value of a bond (Bond Price) and the effective rate of return of bond (i) you should now be able to derive or explain some key bond relationships.

P = C [1 - 1/(1+i)ⁿ]/i   + M/(1+i)ⁿ

Using the above bond formula, your reading assignments and/or basic logic, answer each of the following bond relationship questions in a brief one paragraph posting.

1.   Explain what bond market condition would result the market price of a bond being less than par and what bond market condition would result in the market price of a bond being greater than par.

2. Explain what happens to the market price of a bond as the bond approaches its maturity date and why this happens.

Answer 1

1. Market price of a bond will be less than par when the current yield is higher than the fixed coupon rate of the bond.

In other words the interest rates (“i” in the formula provided) have risen since the issue of the bonds and have become more than the coupon rate of the bond. When this bond market condition prevails investors will not find it attractive to invest in bonds and so they are offered a discount. This leads to the bonds trading below par.

Market price of a bond will become greater than par when the reverse situation takes place i.e. fixed coupon rate of the bond is higher than the current yield. This will happen when interest rates have fallen since the issue of the bonds.

2. As a bond approaches its maturity date its market price move closer to its face value. This happens because majority of the coupons have been paid and so the price of the bond will be mainly consist of the discounted value of the maturity value (or the face value). In other words as the bond approaches its maturity date the only cash flow that is left is the principal value (as most of the coupons have already been paid).