Question

Suppose you want to invest on long term bonds. Your options are to purchase either a 10- year zero coupon (discount) bond or a 10-year coupon bond. Assume that you are considering to sell the bond in two years. Which option has lower interest rate risk? Why? Provide an example and/or some intuition to support your answer. Would your answer change if you hold the bond until the end of the maturity? Explain. Hint: Note that a 10-year discount bond will make the whole payment (face value and interest) at the end of 10 years, whereas a 10-year coupon bond will make coupon payments each year and the face value plus the coupon at the end of 10 years.

Answer 1

A discount bond is a bond that is issued for less than its par or face value . A coupon bond issuer borrows capital from the bondholder and makes fixed payments to them at a interest rate for a specified period that includes attached coupons and periodic interest payments.

Bonds and interest rate has an inverse relationship. Bonds with a lower coupon rate have higher interest rate risks because lower coupon bond's duration is higher than that of higher coupon bond. Also price of a bond is the present value of its cashflows dicounted at the prevailing yields.

The larger duration of longer term securities means higher interest rates risk for those securities.There are two primary reasons why long-term bonds are subject to greater interest rate risk than short-term bonds:

There is a greater probability that interest rates will rise (negatively affect a bond's market price) within a longer time period than within a shorter period. As a result, investors who buy long-term bonds but then attempt to sell them before maturity(here after 2 years) may be faced with discounted market price when they want to sell their bonds. With short-term bonds, this risk is not as significant because interest rates are less likely to substantially change in the short term.Short-term bonds are also easier to hold until maturity, thereby removing an investor's concern about the effect of interest rate-driven changes in the price of bonds.

Long term bonds bonds have a greater duration than short-term bonds. Duration measures the sensitivity of a bond's price to changes in interest rates.For instance, a bond with a duration of 2.0 will lose $2 for every 1% increase in rates. Because of this, a given interest rate change will have a greater effect on long-term bonds than on short-term bonds.