Susan has a 5-year “bunny bond” with a yield to maturity of 6.4% that will be au
ID: 2772456 • Letter: S
Question
Susan has a 5-year “bunny bond” with a yield to maturity of 6.4% that will be automatically reinvested next month. She is considering liquidating the bond and reinvesting in a 10-year 3.5% coupon bond with a yield to maturity of 6.5%. Market rates are very unstable and are just as likely to rise or fall over Susan’s 5 year time horizon. The best action for Susan is to
A: Invest in the 10-year bond since the yield is higher
B: Invest in the 10-year bond because it has greater maturity
C: Invest in the 10-year bond since the coupons can be reinvested
D: Reinvest in the “bunny bond” to avoid lost of accrued interest
E: Reinvest in the “bunny bond” to lock-in the yield
Explanation / Answer
Option D:
Even though if they choose investing in year bond, there would always be reinvestment risk with the coupon payments. The only way to reduce this reinvestment risk is bunny bonds. Therefore, they should choose investing in bunny bonds and avoid loss of interest on coupons.
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