Final answer:
A perpetual bond pays a fixed interest rate indefinitely. If market interest rates rise, the value of the bond decreases and it must be sold at a discount to remain attractive to investors. This principle also applies to regular bonds nearing maturity, where the purchase price should be less than face value if interest rates have risen.
Step-by-step explanation:
Understanding Perpetual Bonds and Market Interest RatesWhen you decide to buy a perpetual bond, you are buying a bond that makes payments indefinitely at a fixed interest rate. However, it is essential to consider the risk associated with the bond. A bond issued with no risk is assumed to be sold at its face value, for example, $1,000, and will pay an annual interest - for instance, $80 per year if the interest rate is 8%. But, if the market interest rates increase to 12%, the bond becomes less attractive compared to new bonds offering higher yields. To attract investors, the seller would need to discount the price of the 8% bond below its face value of $1,000.Let's apply this to another scenario where a local water company issued a $10,000 ten-year bond at 6%. If you are looking to buy this bond one year before maturity, but the current interest rates have risen to 9%, you would expect to pay less than $10,000 for this bond because of its lower yield compared to the market rate. To calculate how much to actually pay for the bond, you would discount the future cash flows (both the final year’s interest and the principal repayment) at the current market rate of 9%.