Question

Answer the following questions:

1. Suppose the interest rate (and therefore the yield to maturity) increases by the same amount on Treasury bill and bonds. Which would you prefer to be holding when the increase in the interest rate takes place: a one year Treasury bill or 20-year Treasury bond? Why?
2. If the holder of the bond sells the bond before maturity, will the rate of return on the bond equal its yield to maturity? Why or why not?
3. Suppose long-term U.S. Treasury bonds have no default risk. Does this mean that long-term U.S. Treasury bonds are risk free? Explain

Answer 1

a. A concept that is important for understanding interest rate risk in bonds is that bond prices are inversely related to interest rates. When interest rates go up, bond prices go down, and vice versa.

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 (and thus 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 may be faced with a deeply 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 alleviating an investor's concern about the effect of interest rate-driven changes in the price of bonds.

Therefore Long term bonds are most sensitive to interest rate changes when compared to short term bonds i.e treasury bills. Hence we will prefer holding short term bonds instead of long term bonds

b.Yield to maturity:Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

Therefore from the above defination we can conclude that rate of return on the bond will not be equal to YTM if such bond is sold before its maturity in other words we can say that rate of return will be less than YTM if such bond is sold before its maturity.

c.U.S. Treasury bonds are generally considered one of the safest means of investments.Financial analysts and the financial media often refer to U.S. Treasury bonds (T-bonds) as risk-free investments. And it's true. The United States government has never defaulted on a debt or missed a payment on a debt. However following are the risks of investing in treasury bonds:

Inflation:Every economy experiences inflation from time to time, to one degree or another. T-bonds have a low yield, or return on investment. A little bit of inflation can erase that return, and a little more can effectively eat into your savings.

Interest Rate Risk:When interest rates rise, the market value of debt securities tends to drop. This makes it difficult for the bond investor to sell a T-bond without losing on the investment.

Opportunity Costs:All financial decisions, even T-bond investments, carry opportunity costs.