Question

A client of yours, George, wants to maximize his return on an intermediate-term bond that he plans to hold until maturity. You have gathered information on the following 2 bonds, both of which have a $1,000 par value.

Bond 1: A rated; coupon rate of 6%; matures in 6 years and pays interest semiannually; currently selling for $850; duration is 5.16 years.

Bond 2: A rated; coupon rate of 10%; matures in 8 years and pays interest semiannually; currently selling for $1,100; duration is 7.15 years.

Which of these bonds would you recommend to George and why?

1. Bond 1, because it is less susceptible to price fluctuations due to interest rate changes

2. Bond 1, because it has a higher yield to maturity than Bond 2

3. Bond 2, because its higher coupon rate gives it a superior total return to Bond 1

4. Bond 2, because it has a higher duration than Bond 1

A. 1 only

B. 2 only

C. 3 only

D. 3 and 4

Answer 1

duration is a measure of how much the bond price would change for a specified change in interest rates. Higher the duration of a bond, higher the change in bond price for each unit of change in interest rates. Lower the duration of a bond, lower the change in bond price for each unit change in interest rates

Bond 2 has higher duration, and therefore its price is more sensitive to changes in interest rates

Bond 1 is recommended to George because  it is less susceptible to price fluctuations due to interest rate changes

YTM and coupon rate are not relevant in measuring the sensitivity of bond price to changes in interest rates

option 4 is incorrect since higher duration means higher sensitivity of bond price to interest rates