Question

Which of the following is INCORRECT regarding interest rates?

		Bonds with greater default risk typically trade at higher yield-to-maturities.
		A positive term premium is caused in part by borrowers’ preference for long duration and lenders’ preference for short duration.
		An inverted yield curve serves as a negative indicator for the future state of the economy.
		Zero-coupon bonds are less sensitive to interest rate changes than coupon bonds with the same time to maturity.
		The yield curve typically slopes upward due to a positive term premium.

Answer 1

"Zero-coupon bonds are less sensitive to interest rate changes than coupon bonds with the same time to maturity". This statement is incorrect. Zero-coupon bonds are more sensitive to interest rate changes because they do not make any interim payments until maturity. Coupon bonds make coupon payments over the bond's life before the principal is repaid, and hence bond investors receive a higher proportion of their payments earlier. Hence, coupon bonds are less sensitive to changes in interest rates.

The first statement is correct. A higher default risk means that the bond investors require a higher return for investing in the bond.

The second statement is correct. Term premium is the excess of long-term yields over short-term yields. A positive term premium is caused in part by borrowers’ preference for long duration (longer term bonds to lock in lower long term interest rates) and lenders’ preference for short duration (lower risk of investing in short term bonds).

The third statement is correct. An inverted yield curve serves as a negative indicator for the future state of the economy because investors are expecting interest rates to fall.

The fifth statement is correct.  The yield curve typically slopes upward due to a positive term premium.