Question

Duration Gap: A bond manager has an investment horizon of 8 years. She purchases a 15- year bond with 6% annual coupon at par. Right after she purchases the bond, interest rates rise. Is this good or bad for the bond manager?

Answer 1

The bond manager has purchased a bond at par for a time horizon that is more than his investment horizon. This means that he will have to sell the bond after 8 years i.e. 6 years before the bond expiry.

As we know, there is an inverse relationship between the bond price and interest rates. Where there is a rise in interest rates, the bond prices fall and when there is a fall in interest rates, bond prices rise.

If we want to know whether it is good or bond for the bond manager that interest rates rise after the purchase, we need to understand our previous statement. The manager will have to sell the bond at the end of 8 years for a lower price than the par value because of the fall in interest rates.

Hence. it is bad for the bond manager if the interest rates fall after the purchase of the bond.

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