Question

You are a bond trader and you expect interest rates to fall. You want to sell bonds that you expect to perform relatively poorly so that you can allocate the funds to the bonds you expect to perform relatively well. Your portfolio currently consists of the following bonds:

• Deutsche Bonds: 25 years to maturity, 2% yield.
• Franco Bonds: 2 years to maturity, 6% yield.
• Aussie Bonds: 30 years to maturity, 3% yield.
• Yankee Bonds: 5 years to maturity, 5% yield.

Which bonds should be removed from the portfolio and which should have the investment allocation increased?

Select one:

a. Deutsche and Aussie bonds should be removed from the portfolio and the investment in Franco and Yankee bonds increased.

b. Franco and Aussie bonds should be removed from the portfolio and the investment in Deutsche and Yankee bonds increased.

c. Franco and Yankee bonds should be removed from the portfolio and the investment in Deutsche and Aussie bonds increased.

d. No bonds should be removed. They are all going to perform equally well.

e. The trader should immediately sell all of the bonds because interest rates are expected to fall.

Answer 1

As interest rates are going to fall, the bonds with highest maturity will show the maximum % increase in price.

There are 2 bonds with long term maturity : Deutsche and Aussie bonds

other two bonds :Franco and Yankee bonds are lower in maturity and hence they will not see that great % change in price as seen by long term maturity bonds , so both should be sold.

so correct answer :

Answer : c :  Franco and Yankee bonds should be removed from the portfolio and the investment in Deutsche and Aussie bonds increased.