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Difficulty: MediumGovernment, Municipal, and Corporate Bonds

A financial advisor is reviewing a client's fixed-income portfolio containing U.S. Treasury bonds, corporate debentures, and municipal revenue bonds. If prevailing market interest rates increase significantly, which of the following statements correctly describes the impact on these debt securities?

  1. The market prices of all three bond types will decline because existing fixed-income security prices move inversely to market interest rates.Answer
  2. B
    U.S. Treasury bonds will maintain their market price because they are backed by the full faith and credit of the U.S. government and carry no credit risk.
  3. C
    The annual coupon interest payments of the existing bonds will increase proportionally to match the higher prevailing market yields.
  4. D
    Municipal revenue bond prices will rise as investors shift capital into tax-exempt securities to offset rising interest rates.

Answer

The market prices of all three bond types will decline because existing fixed-income security prices move inversely to market interest rates.
The correct option correctly applies the fundamental inverse relationship between interest rates and bond prices. When market interest rates rise, prices of existing fixed-rate debt securities fall so their yields adjust upward to match current market conditions. This market dynamic applies equally to U.S. Treasury, corporate, and municipal bonds.

Step-by-Step Solution

1
Identify the primary risk factor acting on the portfolio.
The risk factor is interest rate risk (an increase in prevailing market interest rates).
Market interest rate fluctuations impact existing fixed-income debt securities across all issuer categories.
2
Apply the fundamental price/yield relationship rule for fixed-income instruments.
Bond prices and market interest rates share an inverse relationship (Price∝1YieldPrice \propto \frac{1}{Yield}).
When market rates rise, newly issued bonds offer higher yields, making existing lower-coupon bonds less attractive unless their market price drops to offer a competitive yield.
3
Evaluate issuer differences (Treasury, Corporate, Municipal) against interest rate risk.
All fixed-rate bonds suffer market price depreciation when interest rates rise, regardless of default risk or tax status.
Lack of default risk (Treasuries) or tax exemption (Municipals) does not exempt a bond from market/systematic interest rate risk.

Key Concept

Inverse Relationship Between Bond Prices and Market Interest Rates
Estimated Time:1m 15s
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Topics

Government, Municipal, and Corporate Bonds

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