Question

You have a 7 year investment horizon and are considering one of three bonds to purchase. Bond A has a 5 year duration and a 7 YTM. Bond B has a 15 YTM and 10 year duration. Bond C has a 7 year TYM and 5 year duration. Describe the conditions in which you would choose to purchase each bond.

Answer 1

We have,

Bond A    5 yr duration 7 YTM

Bond B 10 yr duration 15 YTM

Bond C 5 yr duration    7 YTM

Bond A & Bond C are similar and therefore do not require any comparison.

Significance of Duration: The higher the duration of a bond, the greater is it % price sensitivity to interest rates, implying higher duration means higher interest rate risks.

Significance of YTM: YTM also indicates the sensitivity to interest rates, but also higher YTM indicates higher yield and probably lower credit rating, implying higher YTM indicates higher credit risk.

Therefore, select bond A/bond C when interest rates are expected to be very volatile and/ or in declining business growth where firms are defaulting.

and, select bond B when interest rates are expected to be less volatile and/ or in increasing business growth where firms are profiting.