Question

what should I buy if the Fed is raising rates due to a strong economy and the government is cutting taxes? A. Treasury Bonds B. Medium term higher yield corporate bonds C. Longer term Municipal bonds D. 20 yr below investment grade bonds

Answer 1

Due to rising interest rates, the bonds having higher yield do not fall a lot due to the rising interest rates. So, in theses situations the bonds which are in the junk category and high yield bonds are preferred, as a bond with a coupon rate of 4% will fall more in comparison to a bond with a coupon rate of 8%.

In this problem, the treasury bonds and long term municipal bonds are ruled out, firstly due to the lower coupon rate it provides, plus the long term municipal bonds will have a higher duration, and more will be it's sensitivity to a rise in interest rates. The bond prices will fall by a higher amount.

20 yr below investment grade bonds : junk bonds are preferred in times of rising interest rates, but due to the high duration of this bond the price will fall by a higher amount due to the rising interest rates.

So, the medium term higher yield corporate bind should be purchased :

• due to the high yield, the price will not fall much in times of rising interest rates
• the medium duration of this bond, hence the lower duration will make the bond less sensitive to the rise in interest rates.
• the lower taxes, will also provide the bond holder with a higher after tax return .

The correct option is option B.