Final answer:
Bonds are priced based on the coupon rate and market interest rates. A bond will be priced below its face value if the coupon rate is less than market rates, as investors will require a discount to match the prevailing rates. Conversely, a bond will be above face if its rate exceeds the market, making it a more attractive investment.
Step-by-step explanation:
The valuation of bonds is heavily dependent on the relationship between the coupon rate of the bond and the prevailing market interest rates. When a bond's coupon rate is lower than the market interest rate, its price will fall below its face value because investors could get a better return from the market. Conversely, if the coupon rate is higher than the market rate, its price will rise above its face value as it represents a better investment opportunity than what is currently available in the market.
For example, if a bond with a face value of $1,000 pays 8% interest annually ($80 per year) and market rates rise to 12%, the bond's price will drop. An investor would not pay more than $964 for this bond, as investing $964 at the current 12% market rate would yield the same $1,080 a year from now that the bond would pay.
In the case of a large company issuing bonds in the amount of $10 million at an 8% interest rate, it agrees to pay $800,000 per year in interest, and after 10 years, it will repay the initial $10 million. Each bond may have a face value that enables individual investment, such as $5,000 per bond. Bondholders have the legal right to take the company to court if it fails to make the promised interest payments, although recovery of funds is never guaranteed if the company lacks sufficient assets to pay off the bonds.