Question

From a rate of return perspective, if you buy a bond and during your holding period the yields on all bonds decrease by the same amount, which bond would you have preferred to be holding?

Select one:

a. 1-year Treasury bill.

b. 5-year Treasury note.

c. 10-year Treasury bond.

d. 30-year Treasury bond.

Answer 1

We know that the longer the term of the bond, the greater the price fluctuation that results from any change in interest rates. Let us explain what it means.

We are holding a bond which pays specific interest rate. In our holding period, the yield on all bonds drops. Remember that our bond still pays the same as earlier. The yield on all other bonds has fallen. Given that our bond still pays older (and higher) interest rate, its price increases. And the longer the term of the bond, the higher the price increase will be. After all, a 30 year bond will pay this higher interest rate for 30 years!

So, as the price of 30 year bond will increase the most, we will prefer to be holding a 30 year Treasury bond. Hence, Option D is correct.