Question

Suppose you have a 5 year investment horizon and you are considering one of the following three bonds:

Bond Duration Maturity

Bond 1: 8 years 10 years

Bond 2: 5 years 7 years

Bond 3: 3 years 6 years

If you do not know which way interest rates may move and you wish to ensure you earn the promised yield which of the three bonds above should you choose? Explain why in terms of the change in sale price and reinvestment income.

Answer 1

Reinvestment Income: Since we don’t know the nature of Interest rates I think it’s better to reinvent the CFs in short term if the interest rates are high so that we can make the required return in a short term

Bond Price: If the interest rates are low Bond Prices will be higher in the market. So if we own the bond we would’ve bought it low and can sell high since interest rates are low in the market.

Keeping all of this in mind bond 3 is the most suitable option

Because the, reinvestment risk will be lower and price risk will be relatively higher.