NASAA Series 66 Uniform Combined State Law ExaminationInvestment Vehicle CharacteristicsMedium
A client is looking for an investment that provides income, has a stated maturity date, and offers a fixed interest rate. However, they are concerned about the potential impact of rising interest rates on the value of their investment. Which of the following investment characteristics is most sensitive to interest rate risk?
- AHigh credit quality
- BCall feature
- CShort-term maturity
- DLow coupon rate
Show answer & explanationAnswer & explanation
Correct answer: D. Low coupon rate
Bonds with lower coupon rates are more sensitive to interest rate changes because a larger proportion of their total return comes from the principal repayment at maturity, making their present value more susceptible to discounting at new market rates. Conversely, a higher coupon provides more income to offset price declines.
Why the other options are wrong
- A. High credit quality primarily relates to default risk, not directly interest rate risk.
- B. A call feature primarily introduces reinvestment risk for the investor, not increased sensitivity to interest rate changes for the bond's price.
- C. Short-term maturity bonds are less sensitive to interest rate risk than long-term bonds.
Interest Rate Risk (Bond Sensitivity)
The risk that changes in market interest rates will negatively affect the value of a bond or other fixed-income investment. Bonds with longer maturities and lower coupon rates are more sensitive to interest rate fluctuations.
- Inverse relationship between bond prices and interest rates.
- Longer maturity = higher interest rate risk.
- Lower coupon rate = higher interest rate risk.
- Duration measures a bond's interest rate sensitivity.
Memory trick: Longer term, lower yield, more pain when rates yield.