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Which bond should I pick if both have the same YTM, tenor, credit risk? One has a higher coupon rate than the other.

Ixeua

New Member
Suppose I am presented 2 bonds

YTMCoupon
A5%6%
B5%4%

Given that both bonds have the same YTM, tenor, credit risk would either bond be better than another?

A couple of things come to mind. In particular that the Macaulay duration (how fast an investor gets their money back) of bond A is shorter than that of bond B. Would there be any scenarios when B would be a better pick?
 

lushukai

Active Member
Subscriber
Hi @Ixeua ,

I guess another necessary assumption would be that both bonds would be the same price? In that case, the principal of bond A is less than bond B (that you receive back at the end of the bond tenor).

My experience tells me that when interest rates are decreasing, bond B would be a better choice as the duration of bond B is greater than bond A, which causes the price of bond B to increase greater than bond A. This makes it a better hedge in a bond-equity portfolio.

Hope this is helpful!
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
HI @lushukai I don't think they can be the same price: For A, y<c such that p>100. For B, y>c such that p<100. I'm not sure that price per se is an issue: I think the (most common) unstated assumption, for comparison purposes, is that you have the same (eg) $1,000 or $10,000 to invest in either. So, you just end up buying different face amounts given the same value.

The textbook answer is that Bond A offers higher re-investment risk: slightly more coupon income to reinvest along the way (which is related to its lower duration, as there is a trade-off between re-investment and rate/duration risk).

The other thought I had is that Bond A is a premium-priced bond (i.e., y<c --> p>100) and, pulling to par, experiences a small capital loss. So there is a slight tax difference, I think. But it's not a really well-worded question, actually. I hope that's interesting!
 

Ixeua

New Member
Hi Thanks! Could you go into detail into the hedging part? A lot of books I read don't include strategies on bond hedging so I am interested on how bond hedging strategies work.
 

Ixeua

New Member
Hi @Ixeua ,

I guess another necessary assumption would be that both bonds would be the same price? In that case, the principal of bond A is less than bond B (that you receive back at the end of the bond tenor).

My experience tells me that when interest rates are decreasing, bond B would be a better choice as the duration of bond B is greater than bond A, which causes the price of bond B to increase greater than bond A. This makes it a better hedge in a bond-equity portfolio.

Hope this is helpful!
Hi @David Harper CFA FRM. The hedging bit was in reply to @lushukai 's answer here.

If you are asking about the original question, that was purely theoretical. Not from any particular source.
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Thanks @Ixeua appreciated, just wondered if the original question had a source. I realize your f/up was in reply to Lu Shu's answer. I think he just means that a hedge might prefer the hedge position to be more sensitive (i.e., higher duration) to interest rates. I don't have time to go into that huge topic. Our Tuckman text covers it quite in depth with many examples. Thanks,
 

Ixeua

New Member
Thanks @Ixeua appreciated, just wondered if the original question had a source. I realize your f/up was in reply to Lu Shu's answer. I think he just means that a hedge might prefer the hedge position to be more sensitive (i.e., higher duration) to interest rates. I don't have time to go into that huge topic. Our Tuckman text covers it quite in depth with many examples. Thanks,
I am new here. Could you direct me to that? I would really appreciate it.
 

lushukai

Active Member
Subscriber
HI @lushukai I don't think they can be the same price: For A, y<c such that p>100. For B, y>c such that p<100. I'm not sure that price per se is an issue: I think the (most common) unstated assumption, for comparison purposes, is that you have the same (eg) $1,000 or $10,000 to invest in either. So, you just end up buying different face amounts given the same value.

The textbook answer is that Bond A offers higher re-investment risk: slightly more coupon income to reinvest along the way (which is related to its lower duration, as there is a trade-off between re-investment and rate/duration risk).

The other thought I had is that Bond A is a premium-priced bond (i.e., y<c --> p>100) and, pulling to par, experiences a small capital loss. So there is a slight tax difference, I think. But it's not a really well-worded question, actually. I hope that's interesting!
Thank you David! I should definitely know this (especially on the bond premium/discount portion + pulling to par) ... it is part of my full-time job as well ;)
 
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