Interview Question: Durable Bonds for Confusing Days

Sample Question #81 (finance – bond pricing)

[Given the recent turmoils in the credit markets, here’s another fixed income question – a real one asked at interviews!]

I have two bonds, one with a long duration and the other with a short duration. I expect the bond market to be bearish. Which bond should I buy?

What if instead having an opinion on the market direction, I expect the bond market to have higher-than-usual volatility? Which bond should I buy?

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One Response to Interview Question: Durable Bonds for Confusing Days

  1. Brett says:

    ANSWER
     
    Part 1: A bond’s duration tells us the bond’s approximate price change given a small change in the yield. Assuming the market doesn’t just have its bottom falling out, a bear market means the longer-duration bond will drop more in price than the shorter-duration bond. So own the shorter-duration bond to minimize loss. (Of course, you can also just say, "own neither!" But then, what should you invest in?)
     
    Part 2: There’s no answer to this question because what you should do depends on your risk tolerance as well as how you plan to use the bonds (e.g., the characteristic of your target portfolio). 

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