Question

Over the last year the inflation rate was 3.8 percent and the interest rate on US Treasury Bonds was slightly below 2 percent. As an investor in bonds

a. what would you expect to happen to interest rates?

b. using the three bond rules, in terms of prices, maturity, and coupon rates, what type of bonds should an investor purchase? Explain.

c. Which bond is more price sensitive, a zero coupon 20 year to maturity government issued bond or a 5 percent coupon AAA rated 20 year corporate bond? Explain why?

d. Which bond is more price sensitive, a 8 percent coupon bond that matures is 6 years or a 8 percent bond that matures in 4 years? Why?

Note: the concept of a bond’s duration allows bonds of different coupons and maturity dates to be compared in terms of price sensitivity.

Answer 1

Answer(a): Interest rates will increase because inflation is higher but interest rate on US treasury bond is lower, investor will demand for higher interest to compensate with inflation hence interest rates are expected to go up.

Answer(b): Investor should purchase a bond with lower price, higher coupon payments and medium term maturity. Long term bonds (20 yr., 30 yr.) have higher inflation and price risk than short term bonds. Short term bonds have lower yields than long term term bonds.

Bonds with 10 year maturity are good to buy because they are less sensitive than longer term bonds (20yr, 30 yr.) and also have higher yield than short term bonds.

Answer(c): Zero coupon bond is more volatile than coupon bonds, zero coupon bond is the bond that provides no coupon while normal corporate bonds provide coupon payments. Zero coupon bonds provide higher return than other coupon bonds, zero coupon bonds are more volatile than corporate coupon bonds.

Answer(d): 8 percent coupon bond that matures is 6 years is more price sensitive than 8 percent coupon bond that matures is 4 years because higher the maturity, higher the interest rate and price risk. When duration of bond is greater, they are more exposed to inflation and price risk.