Before we start to consider other securities, we need to discuss how securities are issued. One primary component of that is the security's par value. Par value, also called the nominal value, is the face value of the security's original price at the time of issue. Once issued, par value never changes. It's also unrelated to a security's market price.

Par value affects both equity securities, like stocks, as well as fixed-income securities like bonds. However, it's most essential for the latter.

Par Value of Stocks

Equity securities, such as common stock, are issued with an extremely low or no par amount. For example, in Apple's ($AAPL) 10-K filing, you can see that their common stock has an unbelievably small value.

Common Stock, $0.00001 par value per share

Why? The answer is beyond the scope of the SIE, but certain states mandate a par value. Additionally, that security may not be sold for less than the par amount. To comply with these laws, issuers set the par value to something impossibly low.

Par Value for Fixed-Income Securities

Par value is more important for fixed-income securities like bonds and preferred stock, which we'll discuss next. Like stocks, issuers set the par value at the time of issue. For bonds, par value is typically $1,000. For preferred stock, the par value is $100. These amounts are what the issuer promises to return to the investor at the time of maturity.

For example, consider a $1,000 par bond that matures in 30 years. In 30 years, the issuer will repay the investors $1,000 for redeeming the bond. Additionally, there is a coupon rate, which is the amount of annual payments an investor receives each year from a company. If this were 5%, an investor would get $50 each yeah (5% of $1,000). If the bond instead had a par value of $100, the investor would only get $5 each year (5% of 100).

Par value is not the market value for a security. The market price could be lower, the same, or higher than par value. Consider a $100 par security with a 5% coupon rate issued during a time where interest rates were 5%. In this environment, you're keeping up with inflation, but not earning any additional profit. If interest rates rise, say to 10%, that security is no longer keeping up with inflation. In fact, if you had liquid cash at the moment, you could get a security with a 10% coupon rate for the same price you previously bought your 5% security. Which would you rather have?

Trading at a Discount

With higher interest rates, securities with lower coupon rates drop in value because not as many investors wish to purchase them. As such, the market price drops below par. This is known as trading at a discount. An investor would be purchasing a security at a discount relative to par.

Now, this can still be profitable to the keen investor. Looking at an extreme, would you purchase a $100 security with a 5% coupon for $1? I would! That's a 5 times return on your money annually. While no investor would sell at this price, it shows that there is some point where buying the security is a wise move. We can quantify this by looking at the current yield.

While the coupon rate only looks at the par and annual income, the yield instead looks at the annual income and the price that the security was or would be purchased at.

Current Yield = Annual Dividend ÷ Current Market Price

As in the extreme example above, if we bought that security for $1, the yield would be $5 ÷ $1, or 500%. In a more realistic scenario, if that security traded instead at $80, the yield would be 6.25% ($5 ÷ $80). Notice that even though the coupon rate is 5%, the current yield is greater at 6.25%. Securities that trade at a discount always have a higher yield than the coupon rate.

Trading at a Premium

Let's consider the opposite, again with our example of a 5% security at $100 par. If the Fed suddenly ropes in inflation, say to 2%. Now, no one is issuing bonds at 5% because money is so cheap to borrow. All the sudden that 5% security that was already issued becomes much more valuable, as more investors want it. As a result, the market price for that security rises. When the market price exceeds par, the security trades at a premium.

What if the market price for that security with 5% coupon rate rises to $125, $25 over par? We can use the same formula to determine the current yield.

Current Yield = Annual Dividend ÷ Current Market Price

Current Yield = $5 ÷ $125

Current Yield = 4.0%

So it's not quite the 5% that the original investor received, but it's potentially better than what other issuers are currently offering. Securities that trade at premium always have a lower current yield than the coupon rate. We can graphically represent this, as in the chart below. The red line represents a coupon trading at a premium, contrasted with the green line that depicts a security trading at a discount. The blue line in the middle represents par. If a security trades at par in the marketplace, its current yield is equal to its coupon rate.