honeycfa

Maria Cavilero, a bond investor, is most concerned with price volatility. All else equal, which of the following fixed-coupon bonds would she most likely buy? A fixed coupon-bond with:

A) 10 years to maturity and a 6.5% coupon.

B) 10 years to maturity and an 8.5% coupon.

C) 15 years to maturity and an 8.5% coupon.

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This question is asking: given a change in yield, which of the bonds will exhibit the least price change? Of the four choices, Cavilero is most likely to buy the bond with the shortest maturity and highest coupon because it will have the least price volatility. Price volatility is directly related to maturity and inversely related to the coupon rate.

All else equal, the bond with the shorter term to maturity is least sensitive to changes in interest rates. Cash flows that are further into the future are discounted more than near-term cash flows, so the nearer to maturity the cash flows are received, the higher the present value. Here, this means that one of the 10-year bonds will have the least volatility. Similar reasoning applies to the coupon rate. A higher coupon bond delivers more of its total cash flow earlier than a lower coupon bond. All else equal, a bond with a higher coupon will exhibit less price volatility than a lower-coupon bond. Here, this means that of the 10-year bonds, the one with the 8.50% coupon rate will exhibit less price volatility than the bond with the 6.50% coupon.

honeycfa

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.

honeycfa

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

A) call feature exposes investors to additional reinvestment rate risk.

B) call feature lengthens the bond's duration, increasing price risk.

C) call feature reduces the bond's capital appreciation potential.

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A call provision decreases the bond's duration because a call provision introduces prepayment risk that should be factored in the calculation.

For the investor, one of the most significant risks of  callable (or prepayable) bonds is that they can be called/retired prematurely. Because bonds are nearly always called for prepayment after interest rates have decreased significantly, the investor will find it nearly impossible to find comparable investment vehicles. Thus, investors have to replace their high-yielding bonds with much lower-yielding issues. From the bondholder’s perspective, a called bond means not only a disruption in cash flow but also a sharply reduced rate of return.

Generally speaking, the following conditions apply to callable bonds:

• The cash flows associated with callable bonds become unpredictable, since the life of the bond could be much shorter than its term to maturity, due to the call provision.
• The bondholder is exposed to the risk of investing the proceeds of the bond at lower interest rates after the bond is called. This is known as reinvestment risk.
• The potential for price appreciation is reduced, because the possibility of a call limits or caps the price of the bond near the call price if interest rates fall (also known as price compression).

honeycfa

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

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

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

C) shorter 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.

honeycfa

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) 10% coupon, 25 years to maturity.

C) 5% coupon, 25 years to maturity.

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

honeycfa

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) short maturity bonds with high coupon rates.

C) long maturity bonds with low 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.

honeycfa

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.

honeycfa

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.

honeycfa

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

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

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

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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.

honeycfa

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

A) short-maturity bonds with high coupon rates.

B) long-maturity bonds with low coupon rates.

C) high yield 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.