Question

A bond manager is looking over some of his holdings and portfolios and is thinking about making some changes given certain potential economic changes.

1. If he thinks the Fed is going to raise interest rates to slow down a stronger economy and his Treasury note and corporate bond portfolio has a duration of 10, what does this mean and what should he consider?

1. If the Fed raises rates 1% his bonds will go down 10% and he should move into longer term U.S. Treasury bonds.
2. If the Fed raises rates 1% his bonds will go down 10% and he should move into intermediate term maturity high yield bonds rated BB
3. If the Fed raises rates 1% his bonds will go down 1% and he should move into short term Treasuries bonds
4. If the Fed raises rates 1% his bonds will go down 10% and he should move into longer term junk bonds rated B

Answer 1

The correct answer is option b. If the Fed raises rates 1% his bonds will go down 10% and he should move into intermediate term maturity high yield bonds rated BB

Price change = - Modified duration x % change in price = - 10 x 1% = - 10%; hence price will go down by 10%.

Longer the maturity, longer will be the duration and hence higher will be the sensitivity of the the bonds to the interest rate risk. The bond manager should reduce the duration of the portfolio by shifting towards bonds with relatively lower maturities. Hence, the correct answer is option b.