Why do bond prices go down when interest rates go up? Don’t investors like high interest rates?
Bond prices and interest rates are inversely proportional. So, an increase in interest rates decreases the bond prices.
Changes of the market rates don’t affect the bond’s coupon interest payment or principal repayment. Therefore on the increase of market rates, the bond investors in the secondary market are not willing to pay as much for a claim on bond’s fixed interest.
If the interest rates are lower, investors would not want to invest in such bonds that would lead to its decline.
This inverse relationship between interest rate and present value can be noted from the decrease in present value of future cash flows with increase in discount rate.
Question: Assume you have a one-year investment horizon and are trying to choose among three bonds. All have the same degree of default risk and mature in 10 years. The first is a zero-coupon bond that pays $1,000 at maturity. The second has an 8% coupon rate and pays the $80 coupon once per year. The third has a 10% coupon rate and pays the $100 coupon once per year.
a. If all three bonds are now priced to yield 8% to maturity, what are their prices?
b. If you expect their yields to maturity to be 8% at the beginning of next year, what will their prices be then? What is your rate of return on each bond during the one-year holding period?
Frank Meyers, CFA, is a fixed-income portfolio manager for a large pension fund. A member of the Investment Committee, Fred Spice, is very interested in learning about the management of fixed-income portfolios. Spice has approached Meyers with several questions. Specifically, Spice would like to know how fixed-income managers position portfolios to capitalize on their expectations of future interest rates.
Meyers decides to illustrate fixed-income trading strategies to Spice using a fixed rate bond and note. Both bonds have semi-annual coupon periods. All interest rate (yield curve) changes are parallel unless otherwise stated. The characteristics of these securities are shown in the following table. He also considers a nine-year floating-rate bond (floater) that pays a floating rate semi-annually and is currently yielding 5%.
Spice asks Meyers about how a fixed-income manager would position his portfolio to capitalize on expectations of increasing interest rates. Which of the following would be the most appropriate strategy?
a. Shorten his portfolio duration.
b. Buy fixed-rate bonds.
c. Lengthen his portfolio duration.
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