Final answer:
When the Federal Reserve is anticipated to raise interest rates, the value of existing lower-interest bonds falls. If market interest rates increase, you would expect to pay less for a bond with a lower interest rate. The decision to buy, sell, or hold bonds should be made based on an evaluation of market conditions, investment goals, and risk tolerance.
Step-by-step explanation:
Given the scenario where the Federal Reserve is expected to hike interest rates, holding a 10-year zero-coupon treasury bond that was purchased at a premium 5 years ago may require reevaluation. The relationship between bond prices and interest rates is inverse. When interest rates increase, the prices of existing bonds, especially those with longer maturities and lower coupons, tend to decrease. This is because newer bonds will likely be issued at the higher current interest rates, making the existing bonds with lower rates less attractive.
If you were to consider purchasing a $10,000 10-year bond at a 6% interest rate one year before maturity but the current market interest rate is 9%, you would expect to pay less than $10,000 for this bond. The bond is now less attractive because you can potentially get a better return elsewhere due to the higher interest rates. To calculate what you would be willing to pay for this bond, you would need to find the present value of the bond's cash flows (interest payments and principal repayment at maturity) discounted at the new market interest rate.
As for the best decision to make today, buying more long-term bonds might not be wise as their values could decline if interest rates rise. Selling the existing bond before rates rise could potentially allow you to avoid a loss in its market value. Buying low coupon short-term bonds could be more attractive since they would be less affected by interest rate changes. Selling short-term high coupon bonds might not be ideal if market interest rates are expected to increase, as these bonds may currently hold better value. Ultimately, the best decision would depend on risk tolerance, investment goals, and market expectations.