Question

Scenario: I can get a new bond from a company with a 10yr maturity and and a 5% yield (for par value) or I can buy an existing bond (from the same company) with a 10yr maturity and a 4% yield... Would I pay the same, more, or less for the existing bond (compared to the new bond)... and what risk does this represent when investing in fixed income?

Answer 1

Existing bond will be priced higher than the bond that can be received from the company because the interest rate in the markets have gone down and price and interest rates are inversely related. To acquire the existing bond, therefore you will have to pay more. This is because when the interest rate in the market goes down, issuer tries to refinance the bonds as he can now get the debt capital at a lower interest rate. Therefore, the price of such bonds increase as the the discount rate or the market interest rate decreases, so the CFs of the bonds have higher PV.

When investing in fixed income securities, this is called the interest rate risk. If the interest rate riske the value of the bond decreases as the CFs are discounted at a higher rate while if they go down then the price increases. This is measured by duration of the bond and therefore, bonds with higher coupons have lower duration and zero coupon bond has higet duration because the initial investment is recovered quickly in the bonds with higher coupons while in zero coupon bond, the investment is recovered only at the time of maturity.