Reading 62: Risks Associated with Investing in Bonds-LOS c 习 manager

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Session 15: Fixed Income: Basic Concepts
Reading 62: Risks Associated with Investing in Bonds

LOS c: Explain how features of a bond (e.g., maturity, coupon, and embedded options) and the level of a bond's yield affect the bond's interest rate risk.

 

 

If a portfolio manager anticipates a major increase in market interest rates, the most appropriate trading strategy is to purchase:

A) long-maturity bonds with low coupon rates.

B) high yield bonds with high coupon rates.

C) short-maturity bonds with high coupon rates.

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The price volatility of non-callable bonds is inversely related to the level of market yields. As yields increase, bond prices fall, and the price curve gets flatter. Bonds with higher duration will change more in price. Longer maturity bonds with lower coupon rates are more sensitive to interest rate risk and their price will decrease more than short term, high coupon rate bonds. High yield ("junk") bonds with high coupons become more risky in high interest rate environments and therefore would not be appropriate.

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Which of the following statements about a bond with a call feature is least accurate? The call feature:

A) reduces the bond's capital appreciation potential.

B) increases the bond's duration, increasing price risk.

C) exposes investors to additional reinvestment rate risk.

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A call feature decreases a bond's duration.

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Of the following three otherwise identical bonds, which is likely to exhibit the greatest price volatility?

A) 5% coupon bond with 20 years to maturity.

B) 10% coupon bond with 10 years to maturity.

C) 10% coupon bond with 20 years to maturity.

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This question is asking: given a change in yield, which of the bonds will exhibit the greatest price change? Of the three choices, the bond with the longest maturity and lowest coupon will have the greatest price volatility. 

All else equal, the bond with the longer term to maturity is more sensitive to changes in interest rates. Cash flows that are further into the future are discounted more than near-term cash flows. Here, this means that one of the 20-year bonds will have the highest volatility. Similar reasoning applies to the coupon rate. A lower coupon bond delivers more of its total cash flow (the bond's par value) at maturity than a higher coupon bond. All else equal, a bond with a lower coupon than another will exhibit greater price volatility. Here, this means that of the 20-year bonds, the one with the 5% coupon rate will exhibit greater price volatility than the bond with the 10% coupon.

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What will happen to interest rate risk for an option-free bond if market yields decrease?

A) Interest rate risk will decrease.

B) Interest rate risk will increase.

C) Even if the term structure is flat, interest rate risk could go up or down based on the level of the term structure at the time market yields decrease.

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If market yields decrease, interest risk will increase since the duration or the sensitivity of the bond to interest rate fluctuation will increase.

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Which of the following bond features would result in lower interest rate risk? A:

A) lower coupon rate.

B) higher yield to maturity.

C) longer maturity.

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A higher yield to maturity would result in a shorter duration and lower interest rate risk. A longer maturity and lower coupon rate would result in longer durations and higher interest rate risk.

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Tom Wilkens is a portfolio manager and has a retiree as a client. The client would like to invest in bonds with low interest rate risk. Which bond should Tom choose for his client? The bond with a:

A) 20 year maturity and a yield to maturity of 5%.

B) 10 year maturity and a yield to maturity of 5%.

C) 10 year maturity and a yield to maturity of 8%.

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The shorter the bond’s maturity and the higher the yield to maturity, the shorter the duration and the lower the interest rate risk.

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All else equal, the lower the bond’s yield to maturity, the:

A) shorter the duration and the lower the interest rate risk.

B) shorter the duration and the higher the interest rate risk.

C) longer the duration and the higher the interest rate risk.

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A lower yield to maturity would result in a longer duration and higher interest rate risk.

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Which of the following bonds, all else equal, would be the most sensitive to interest rate changes?

A) 10% coupon, 5 years to maturity.

B) 5% coupon, 25 years to maturity.

C) 10% coupon, 25 years to maturity.

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Long-term, low coupon bonds are more sensitive to rate changes.

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A portfolio manager anticipates a major increase in market interest rates. Which trading strategy would be most likely to generate above average returns in a bond investment? Purchasing:

A) bonds that will increase the average duration of the investment portfolio.

B) long maturity bonds with low coupon rates.

C) short maturity bonds with high coupon rates.

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The price volatility of non-callable bonds is inversely related to the level of market yields. As yields increase, bond prices fall, and the price curve gets flatter. Bond price sensitivity is lowest when yields are high. Longer maturity bonds with lower coupon rates are more sensitive to interest rate risk and their price will decrease more than short term, high coupon rate bonds.

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Which of the following is closest to the maximum price for a bond that is currently callable?

A) Its par value.

B) The call price.

C) Its par value plus accrued interest.

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When interest rates fall, causing the price of the bond to increase above the call price, the issuer is likely to call the bond. Therefore the call price acts as a limit on the bond price.