Question

Suppose you have a 5 year investment horizon and you are considering one of the following three bonds:

Bond Duration Maturity

Bond 1 8 years 10 years

Bond 2 5 years 7 years

Bond 3 3 years 6 years

If you believe interest rates will fall and you wish to earn more than the promised yield which of the three bonds above should you choose? Explain why in terms of the change in sale price and reinvestment income.

Answer 1

We know that there is an inverse relationship between bond prices and interest rates. In this case, since the investory expects teh rate of interest to fall, the expected direction in the prices of these bonds is upwards.

We also know that while a longer maturity bond will be affected more by teh changes in rate of interest than a shorter maturity bond, a precise way to find out the quantum of expected change is to use duration. A 1% fall in rate of interest would cause 1%*d rise in the price of bond where d is duration. If we see the three bonds given above, we see that bond 1 has the longest duration of 8 years and hence I should choose these to invest my money in.