FINRA Series 7Investment Information and Suitable RecommendationsMedium
A client is considering two bonds of similar credit quality: Bond A has a 5-year maturity and a 7% coupon, while Bond B has a 10-year maturity and a 7% coupon. If interest rates in the market increase by 1%, which bond would likely experience the greater percentage decrease in market value?
- ABond A, because it has a higher coupon rate.
- BNeither bond would decrease, as they have the same coupon.
- CBoth bonds would experience an equal decrease.
- DBond B, because it has a longer maturity.
Show answer & explanationAnswer & explanation
Correct answer: D. Bond B, because it has a longer maturity.
Bonds with longer maturities are more sensitive to changes in interest rates than bonds with shorter maturities. This is because the present value of distant cash flows (future interest payments and principal repayment) is more significantly impacted by a change in the discount rate. Therefore, Bond B, with its 10-year maturity, would experience a greater percentage decrease in market value.
Why the other options are wrong
- A. Higher coupon bonds generally have less interest rate risk than lower coupon bonds of the same maturity, but maturity is the dominant factor here.
- B. This is incorrect; all bonds (except floating-rate bonds) are subject to interest rate risk, regardless of coupon rate, and their prices will move inversely to interest rates.
- C. This is incorrect; maturity plays a significant role in interest rate sensitivity.
Interest Rate Risk (Bonds)
The risk that changes in market interest rates will negatively affect the value of a bond or other fixed-income investment.
- Bond prices move inversely to interest rates.
- Longer maturity bonds have greater interest rate risk.
- Lower coupon bonds have greater interest rate risk (for a given maturity).
Memory trick: Interest rates up, bond prices down. Long maturity means bigger frown.