Question

1. Jacob and Michelle are assistant portfolio managers. Senior portfolio manager Ronald has asked them to consider purchasing one of two option-free bond issues with the following characteristics:

Issue 1 has a lower coupon rate than Issue 2

Issue 1 has a shorter maturity than Issue 2

Both issues have the same credit rating.

Jacob and Michelle are discussing the interest rate risk of the two issues. Jacob argues that Issue 1 has greater interest rate risk than Issue 2 because of its lower coupon rate. Michelle counters by arguing that Issue 2 has greater interest rate risk because it has a longer maturity than Issue 1.

Which assistant portfolio manager is correct with respect their selection to the issue with the greater interest rate risk? Or are neither correct? Why?

Suppose that you are the senior portfolio manager. How would you suggest that Jacob and Michelle determine which issue has the greater interest rate risk?

Answer 1

Bonds with higher coupons have lower interest rate risk because a higher portion of the bond's payments are received sooner.

Bonds with longer maturity have higher interest rate risk because there is a longer time left until the bond's payments are received.

Neither manager is correct. Determining which bond has higher interest rate risk cannot be done based solely on the maturity or coupon rates of the bonds. This is because the coupons and maturities of the bonds are different.

I would suggest that acob and Michelle determine which issue has the greater interest rate risk by calculating the modified duration of each bond