Suppose you are managing a bond portfolio that has a Macaulay Duration of 14 yea

Question

Suppose you are managing a bond portfolio that has a Macaulay Duration of 14 years. You predict that market interest rates are going to increase significantly next quarter. You decide to sell some of your current portfolio in anticipation of the interest rate change. You call your bond dealer and he has two zero coupon bonds for sale that fit your portfolio’s investment criteria. One bond has 20 years to maturity and the other has 5 years to maturity. You want this trade to reduce the impact of the change in interest rates on your bond portfolio. Which bonds do you choose to sell? (Long or short duration?) Which bond will you purchase? (The 20 year or the 5 year?) Briefly explain why. Thinking about the relationship between duration and price volatility will help.

Explanation / Answer

With an increase in the interest rates, the prices of bonds tend to decrease. Interest rates and prices of bonds move in opposite directions. The duration of the bond also determines the price of the bond. Generally higher the duration of the bond greater will be the drop in its price with rising interest rates. Hence I would choose to sell the bond which has 20 years to maturity since I expect that the fall in its price will be greater than the decline in the price of the 5 year Bond. I would purchase the bond that has a 5 year duration since it will have a lesser interest rate risk. Short-term bonds tend to lose less than longer-dated securities when rates rise

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