Examkin

Question

Difficulty: HardDebt Securities and Bond Structure

An investor holds two investment-grade corporate bonds issued by the same company with identical credit ratings: Bond X has a 20-year maturity and a 3% annual coupon rate, while Bond Y has a 5-year maturity and a 7% annual coupon rate. If prevailing market interest rates across all maturities instantly increase by 150 basis points (1.50%1.50\%), which of the following best describes the relative market price movement of these two bonds?

  1. Bond X will experience a greater percentage price decline than Bond Y because securities with longer maturities and lower coupon rates possess higher interest rate volatility.Answer
  2. B
    Bond Y will experience a greater percentage price decline than Bond X because higher coupon debt securities carry greater capital loss exposure when rates increase.
  3. C
    Both bonds will decrease in price by identical dollar amounts because the interest rate change is uniform across the entire yield curve.
  4. D
    Bond X will increase in price while Bond Y decreases in price because an upward shift in rates creates an immediate inversion in corporate bond pricing hierarchies.

Answer

Bond X will experience a greater percentage price decline than Bond Y because fixed-income securities with longer maturities and lower coupon rates exhibit greater duration and price volatility when interest rates change.
Bond price volatility in response to interest rate movements is governed by duration. Bonds with longer maturities and lower coupon rates have higher duration, meaning their secondary market prices fluctuate more significantly when interest rates change. Because Bond X has both a longer maturity (20 years vs. 5 years) and a lower coupon rate (3% vs. 7%), it will suffer a larger percentage price decline when interest rates rise by 150 basis points.

Step-by-Step Solution

1
Analyze the inverse relationship between interest rates and bond prices.
When market interest rates increase, existing bond prices must fall so that their yields remain competitive with newly issued debt.
Bond prices and interest rates move in opposite directions.
2
Evaluate the impact of maturity on bond price volatility.
Bond X (20-year maturity) has a longer time horizon until principal repayment than Bond Y (5-year maturity), exposing it to greater interest rate risk over time.
Longer-term bonds have higher duration and experience larger price swings for a given change in interest rates.
3
Evaluate the impact of coupon rate on bond price volatility.
Bond X (3% coupon) pays smaller cash flows prior to maturity than Bond Y (7% coupon), resulting in a higher proportion of its total value being tied to the distant principal payment.
Lower coupon bonds have longer weighted-average cash flow timings (duration), making them more sensitive to interest rate shifts.
4
Combine maturity and coupon factors to determine relative price sensitivity.
Bond X combines both high-risk attributes (longer maturity and lower coupon), causing it to drop significantly more in percentage price terms than Bond Y.
Both factors compound interest rate risk.

Key Concept

Bond Price Sensitivity and Duration Dynamics
Estimated Time:1m 45s
Rate this question

Topics

Debt Securities and Bond Structure

More questions from this topic