Question of the Week

You currently are holding a portfolio of bonds. Interest rates are expected to increase over the next few months. In order to protect your investment, your bond portfolio should contain bonds with the following characteristics:

a) Low convexity and low coupons
b) Low convexity and high duration
c) High convexity and high coupons
d) High duration and high convexity

Answer:

The correct answer is c.

Bonds with high convexity are less affected by changes in interest rates than bonds with lower convexity. Bonds with higher convexity will always have a higher price than a bond with lower convexity, regardless if interest rates increase or decrease.

Bonds with high coupons have lower durations are the least affected by changes in interest rates.

For more on duration and convexity, refer to the Advanced Bond Tutorial.