Suppose there are two different kinds of bonds on the market: High-C and Low-C bonds. Both bonds are issued by the same company and have identical principal, and the same initial maturity (both 30-year bonds). The High-C bonds were just issued with a high coupon rate and the Low-C bonds were just issued with a low coupon rates. If you are expecting that the market interest rate will fall very soon. Which bond will be more attractive for you if you are to sell the bond shortly?
Duration is a measure of a bond's sensitivity to interest rates. Essentially, it measures the length of time (in years) it takes for an investor to recoup his initial investment on a bond. Generally, when holding all else constant, the following rules-of-thumb apply when evaluating duration:
- The longer the maturity, the higher the duration
- The lower the coupon rate, the higher the duration
- The lower the frequency of coupon payments, the higher the duration
Answer and Explanation:
If you are expecting that the market interest rate will fall very soon, the Low-C bonds will be more attractive to me. Given their lower coupon rate, these bonds have a higher duration than the High-C bonds. As a result, they will be more sensitive to interest rate changes. Moreover, given the expectation for rates to fall, the High-C bonds are positioned to experience a greater degree of price appreciation (as prices move inversely with rates and this is amplified by duration).
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fromChapter 3 / Lesson 6
Interest rate risk is really the risk of two different events (price reduction and reinvestment rate reduction) caused by a change in interest rates. Interest rate risk affects bond investments, but the good news for bond investors is that it can be mitigated or eliminated.