Question

If two bonds with different coupon rates have the same maturity, which one will fluctuate more as interest rates change? Explain./

Answer 1

Ans: If two bonds with different coupon rates have the same maturity, the bond which has a lower coupon rate will fluctuate more in comparison to the bond having high coupon rate when interest rates change. This fluctuation is known as Interest Rate Risk.

Explanation:

Interest Rate Risk:

Interest Rate Risk may be defined as the risk associated with the impact of change in interest rate on the price of bonds. An important principle in investment of bonds is that market interest rates and prices of bond are inversely proportional to each other i.e. when market interest rates increases the prices of fixed-rate bonds get decreases and vice-versa.

Factors on which the Impact of Interest Rate Change on Bond Prices Depend:

Generally, the Interest rate risk is reciprocated to all bonds. The effect of change in interest rate on the value of bonds is depend on 3 factors: The Maturity Period of Bond, the Coupon Rate of Bond, and the Presence of Embedded Option in Bond. The Maturity Period and the Coupon Rate of bond usually plays an important role in determining the change in bond price as a result of changes in market interest rates.

The Impact of Coupon Rates on Interest Rate Risk:

If two bonds have different coupon rates but all other characteristics like maturity period, quality of credit etc. are same, the bond which has lower coupon rate will fluctuate more in comparison to the bond having high coupon rate when interest rates change. It means that the lower coupon rate bond mostly will experience a larger reduction in its value as market interest rates increase. Bonds with lower coupon rates usually expose to higher interest rate risk than comparable bonds of higher coupon rates. It can be represented as:

Lower Coupon Rate Bond----------------Higher Interest Rate Risk.

Higher Coupon Rate Bond----------------Lower Interest Rate Risk.

For Example:

If a bond has coupon rate of 10 % and another bond has a coupon rate of 20 %. Both the bonds have same maturity period of 5 years. If interest rates increase, then the value of the bond with the 10 % coupon rate will decrease more than that of the bond with the 20 % coupon rate.

Conclusion:

So, from the above discussion it is clear that if two bonds with different coupon rates have the same maturity, the bond which has a lower coupon rate will fluctuate more in comparison to the bond having high coupon rate when interest rates change. It is due to the relationship of Interest Rate Risk with Low and High Coupon Rate Bonds of same features.