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Which one of the following terms applies to a bond that initially sells?

1) Discount bond
2) Premium bond
3) Par bond
4) Zero-coupon bond

1 Answer

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Final answer:

A bond that sells initially below its face value is known as a discount bond. Market conditions, such as increased interest rates, can lead to bonds being sold at a discount to remain attractive to investors by offering a higher yield.

Step-by-step explanation:

The term that applies to a bond that initially sells below its face value is a discount bond. This is reflected by a bond selling for less than its par value (the amount it will be worth at maturity) when market interest rates rise above the bond's coupon rate. For a bond carrying no risk, it is expected to sell at face value, known as a par bond. If interest rates rise, making the bond less attractive, the price is reduced to offer a better yield that compensates for the lower interest rate in comparison with newer bonds, thereby creating a discount bond.

Let's consider a risk-free bond that has a face value of $1,000 and a coupon rate that pays $80 per year. If the prevailing market interest rates increase to 12%, the bond becomes less attractive since new bonds offer a higher return. To entice an investor to buy this 8% bond, the seller may lower its price below $1,000, making it a discount bond as it offers a higher yield to maturity due to the lower purchase price.

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