Interest Rate Risks

The following is a transcript of the video above

Let’s Try a Practice Question

A client is concerned with the impact of interest rate risk may have on his portfolio and seeks advice on which investment should be avoided. An RR might tell his client to consider minimizing capital investments in

1. Bond anticipation notes
2. 25-year AAA zero coupon bond
3. Exchange- =Traded Funds
4. Treasury notes

The answer here is 2.

How Does Interest Rate Risk Work?

Interest rate risk means that when interest rates go up, the prices of outstanding bonds, all shapes and sizes of bonds in the marketplace, are going to be impacted. That is also just a fact of life. In this question, we are asked for advice on what investments we should avoid. Therefore, stay away from something that is going to be particularly impacted by interest rate risk.

Interest Rate Risk Characteristics

An RR might tell his client to consider minimizing capital investments. If we understand what the question is asking, we are looking for the item or the product that is going to be most grossly impacted, most significantly affected, by the movement of interest rates. When we think about interest rate risk, rates go up, prices go down. Now, we do know that there are different characteristics of a bond that are going to influence how much or how sensitive the price change will be when rates change. Two things that we really focus most heavily on are the maturity of the security, and the coupon of the security. The rule of thumb is that longer-maturity bonds are going to be more interest rate sensitive than shorter-maturity bonds, or shorter-maturity loans.

What Is a Bond Anticipation Note?

This is a type of municipal product. Try to recognize the language “bond anticipation notes,” and that is, of course, a short-term obligation of a state or local government. The keyword here is the word “short-term.” Most municipal notes will mature within a year. While some may go out as far as three, seldom will they be longer than three. The point here is they are short.

Treasury Notes

T-notes are also a note, just in a different way. Treasury notes, you recall from the U.S government structure, are short notes that are midterm bonds, which are long-term. A note at its original maturity would be as long as 10 years to D-Day. Two things in A and D which are not longer than 10 years. We have an exchange-traded fund, which is not even a bond, to begin with, it is an equity security.

How Do You Determine Interest Rate Sensitivity?

Remember, the other variable in determining how much interest rate sensitivity we see is not only maturity but also the coupon of the bond. One rule of thumb that you want to unpack into this conversation, forgetting about maturity, is if we analyze interest rate risk, these are the coupon.

One thing we know for sure, the lower the coupon, the more impactful its price will be a change in interest rates. Low-coupon bonds are more interest rate sensitive than higher-coupon bonds. Therefore, we do not need to understand or worry about the theory there.

One thing that is going to come across loud and clear is that at the end of the day, if you have a Walmart full of bonds, and you ask yourself which ones are going to be the most sensitive, you must find the ones that have the lowest coupons, and you cannot get any lower than zero, and the longest maturities. A 25-year bond is a long time, and it is certainly the longest of all the options here. That is how we arrive at the answer choice B, a 25-year zero coupon bond. We got that answer here with critical thinking, and that is the key point here. It is about collaboration; partnership and sharing ideas.