Question

A committee member suspects that some of Pacific's bond holders are short-term speculators as opposed to long-term investors. He believes that interest rates are going to fall from current levels and asks you which Pacific bond would speculators buy to maximize short-term capital gains and why. (Hint: No additional calculations are required.)

Answer 1

The speculators will buy the long term bonds as against the short term bonds to maximize short term capital gains. They will also buy the older bonds as against the newer bonds issued because the older bonds will carry a higher yield than the newer bonds issued with lower yield. The higher yield of the older bonds will increase the prices of the older bonds.

The reason being the long term bonds have a longer duration and hence are subject to greater movements in bond prices due to interest rate changes.With respect to short term bonds the movements in price will not be much because interest rate is unlikely to change significantly in the short term.

As we know the bond prices are inversely related to change in interest rate. A fall in interest rate will result in increase in bond prices and a rise in interest rates will result in fall in bond price. The bond price movements are more significant in case of long term bonds.When interest rates fall the longer term bonds which will have more coupon payments due during the bond tenure fetching a higher yield will command a higher price. Since short term bonds will have only a few coupon payments left during its tenure the price increase will not be significant when interest rates fall.

Hence the pacific bond speculators will buy the long term bonds when the interest rate are expected to fall to maximize short term capital gains.