I am on the trading section of bonds (3.4). I took the quiz and understood everything except 1 particular question that I can’t seem to make sense of. The question is:
Which statement is true when interest rates fall?
I answered: bonds trading at premiums will rise fastest in price.
The correct answer is: bonds trading at discounts will rise fastest in price.
I understand that if interest rates fall, bond prices rise (and vice versa). However, I’m trying to understand why the answer is bonds trading at discounts. Thank you in advance for your help!!
Hi @Thick_pink_echidna, good question!
[TJ7QF] Which statement is true when interest rates fall?
It’s a complicated topic - here’s the relevant section from our SIE chapter on price volatility for bonds:
Bonds with lower coupons tend to be more sensitive to interest rate changes. To understand this, assume you own two 10 year bonds. One has a 2% coupon, and the other has a 10% coupon.
When interest rates fall, the value of both bonds will rise. The 2% bond rises further because its a big chunk of its value is tied to a discount. Remember, the lower the coupon, the more likely the bond was sold at a discount. When much of the bond’s value is achieved at maturity, there aren’t large sums to reinvest at the new lower interest rate. On the other hand, the 10% bond pays much more interest to its bondholder. If the bondholder reinvests the interest into the market, they are forced to buy bonds with lower rates of return. The 10% bond is less valuable in this situation because it pays more interest that would be reinvested at lower interest rates.
Please let me know if it would help to clarify any of this further!
Btw, you can click on the ID code in the top right to copy a shareable URL to the question, or you can click on the mail icon to pop open a feedback form to send us a message with additional context about the question.
Thanks Justin. I had another bond question that I will list below. Just trying understand what this is meaning from the suitability section:
“Call risk is the worst form of reinvestment risk. Instead of just reinvesting interest received at lower rates of return, the investor must also reinvest the bond’s principal!”
Thanks in advance for your help!
Hi @Thick_pink_echidna - I can answer this. Reinvestment risk occurs when interest rates fall and returns from an investment are reinvested at lower rates. This normally happens with dividend or interest income only, but the problem amplifies when a bond or preferred stock is called. Now the investor must reinvest the par value, which is usually much bigger than the income the investment paid. The more that’s reinvested, the bigger the risk.
Call risk is type of reinvestment risk, and it’s the worst form of it due to the amount being reinvested.