Final answer:
The value of a bond is influenced by market interest rates, and if rates rise, the price of existing bonds must drop to remain attractive to investors. Companies issue bonds to raise capital, and bondholders are entitled to interest payments, though they may only partly recoup their investment if the company defaults.
Step-by-step explanation:
The value of a bond and its attractiveness to investors are greatly influenced by the prevailing interest rates in the economy. When a bond is issued, if it carries no risk, it will typically sell for its face value, such as $1,000, and offer a fixed rate of return – the interest rate. However, if market interest rates rise, the bond, still paying at its original fixed rate, becomes less appealing to investors. To compensate, the issuer must reduce the bond's price below its face value to make it competitive with new bonds paying higher rates.
For instance, a no-risk bond paying 8% interest ($80 per year) would sell at face value at the time of issuance. If interest rates rise to 12%, and the bond has one year left to maturity, new investors would prefer bonds paying the higher rate. To entice them to buy the older 8% bond, its price must drop below $1,000. This price adjustment ensures that the investor will yield a competitive return comparable to the new 12% rate bonds when the investment matures.
Moreover, a large company may issue many smaller bonds as part of a larger capital-raising effort. For example, to borrow $50 million, a firm might issue 10,000 bonds at $5,000 each. Investors who purchase these bonds become bondholders and are entitled to interest payments. However, should the company fail to make the interest payments, bondholders have the right to take the firm to court to recoup their investments, though this doesn't guarantee full recovery should the firm lack sufficient assets.