Question: If you were a member of a bank’s funds management…
If you were a member of a bank’s funds management committee, one of your tasks might require selection of bonds for purchase in the bank’s bond portfolio. Suppose the committee has asked you to select one of two bonds likely to less value in the event prevailing interest rates rise. Both bonds can be purchased at par, they mature on the same date, and third party risk ratings are identical for both bonds. The bonds are essentially identical in all material respects except for coupon payment. Bond A pays a 4.5% semiannual coupon; Bond B pays a 4.0% semiannual coupon. Why should you select Bond A for the bank’s portfolio?
- Bond A’s present value is greater because of the higher coupon payment. This greater value will render a higher yield and therefore a superior investment.
- Bond B’s lower coupon would yield a higher duration and therefore greater volatility.
- Bond A’s present value is less because of the higher coupon payment. This lesser value will render a lower yield and therefore an inferior investment.
- Bond B’s lower coupon would yield a lower duration and therefore less volatility.