NASAA Series 66 Uniform Combined State Law ExaminationClient Investment Recommendations and StrategiesHard
A portfolio manager believes there will be a significant increase in interest rates over the next year. To mitigate the risk of declining bond prices in the client's fixed-income portfolio, the manager should:
- ADecrease the portfolio's average duration.
- BIncrease the portfolio's average duration.
- CShift investments from short-term to long-term bonds.
- DIncrease the allocation to high-yield bonds.
Show answer & explanationAnswer & explanation
Correct answer: A. Decrease the portfolio's average duration.
When interest rates are expected to rise, bond prices will fall. Bonds with shorter durations are less sensitive to interest rate changes than bonds with longer durations. Therefore, decreasing the portfolio's average duration will help mitigate the risk of declining bond prices.
Why the other options are wrong
- B. Increasing duration makes the portfolio *more* sensitive to interest rate changes, exacerbating price declines when rates rise.
- C. Shifting to long-term bonds increases duration, making the portfolio more vulnerable to rising interest rates.
- D. Increasing allocation to high-yield bonds increases credit risk and generally their interest rate sensitivity, not primarily addressing the concern of declining prices due to rising rates for a stable portfolio.
Bond Duration
A measure of a bond's price sensitivity to changes in interest rates. Higher duration means greater price volatility for a given change in interest rates.
- Expressed in years.
- Longer duration = greater interest rate risk.
- Shorter duration = less interest rate risk.
- Used to manage interest rate risk in fixed-income portfolios.
Memory trick: Rising rates: Shorten duration, avoid bond price frustration!