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Market interest rates fall below the fixed rate on a bond already in issue. What happens to that bond's price?
AIt falls, because the coupon is now unattractive
BIt stays fixed, because the par value is fixed
CIt rises, because the bond is now more valuable
DIt falls, because the issuer will call the bond in
Answer & Solution
Correct answer: C. It rises, because the bond is now more valuable
1. A bond pays a fixed rate of interest for its whole life, so its coupon does not move with the market.
2. The price of the bond does move, because it changes over the bond's life as market interest rates fluctuate.
3. When the market rate drops below the fixed rate on the bond, that bond pays more than newly issued ones.
4. It therefore becomes more valuable, and its price rises.
5. The reverse holds when interest rates rise: the bond's price falls, because its fixed coupon now lags the market.
6. Par value is only what the issuer repays at maturity, so it does not hold the traded price steady in between.
_Source: OpenStax Introduction to Business (CC BY 4.0), Ch 16 "Understanding Financial Management and Securities Markets", section 16.6 Securities Markets_
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