Question

You hear on TV a financial advisor making the following statement:

“Given the current uncertainty in the interest rates – e.g. increase/decrease of Fed rates –, investing in long-term bonds is not good idea for investors concerned with the price volatility of their portfolio. They should better invest in short-maturity bonds if the goal is to minimizing price swings following changes in yields.”

The advisor has in mind sudden increases or decreases about the interest rates.

1. Why is this statement is backed up, at least partially, by economic reasoning? Offer a justification for why long-term bonds might be more risky than short-term bonds. [1 point]

2. Why is the statement not completely right? Explain what the advisor might be missing. [2 points]

Answer 1

You hear on TV a financial advisor making the following statement:

“Given the current uncertainty in the interest rates – e.g. increase/decrease of Fed rates –, investing in long-term bonds is not good idea for investors concerned with the price volatility of their portfolio. They should better invest in short-maturity bonds if the goal is to minimizing price swings following changes in yields.”

The advisor has in mind sudden increases or decreases about the interest rates.

1. Why is this statement is backed up, at least partially, by economic reasoning? Offer a justification for why long-term bonds might be more risky than short-term bonds.

Answer: Interest rates and Duration of the Bond are key factors which assess the risk of respective bonds. A long term bond shall carry higher risk due to the fear of higher inflationary trends that cause its value to drop as well as higher interest rates which shall impact its payments. The economic reason of inflation as well as fluctuation in the interest rates is thus justifiable.

1. Why is the statement not completely right? Explain what the advisor might be missing.

Answer: Contrary to the above, Short tem bonds have low duration to capture the downside trend of interest rates, while long term bonds shall be high probaility in their long duration, to get benefited from the downside trend of interest rates. Also, the portfolio managers have flexibility in hedging the instruments for the interest rate risks in long term bonds case and thus can cover the risk aspect to the best extent possible;