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 3% coupon rate, while Bond B has a 10-year maturity and a 3% coupon rate. If interest rates are expected to rise significantly, which bond is more susceptible to interest rate risk?
- ABond B, because it has a longer maturity.
- BBond A, because it has a lower coupon rate.
- CBoth bonds are equally susceptible, as they have the same coupon rate.
- DNeither bond is susceptible to interest rate risk, as they are of similar credit quality.
Show answer & explanationAnswer & explanation
Correct answer: A. Bond B, because it has a longer maturity.
Bonds with longer maturities are more sensitive to changes in interest rates. When interest rates rise, the market value of existing bonds with lower fixed coupon rates falls more significantly for longer-duration bonds.
Why the other options are wrong
- B. While lower coupon rates generally increase interest rate risk, maturity is the primary factor when comparing bonds with similar coupons.
- C. Maturity is a key factor in interest rate risk; therefore, they are not equally susceptible.
- D. All bonds are susceptible to interest rate risk, regardless of credit quality, as it pertains to market value changes due to interest rate swings.
Interest Rate Risk (Bonds)
Interest rate risk is the risk that changes in market interest rates will negatively impact the value of a bond, causing its price to fall. Bonds with longer maturities and lower coupon rates generally have higher interest rate risk.
- Inversely related to bond prices.
- Longer maturity = higher risk.
- Lower coupon = higher risk.
Memory trick: Longer term, Lower coupon, Greater Rate Risk.