Final answer:
A hedge fund selling 29½-year bonds and buying 30-year bonds at a higher yield aims for a market-neutral position, betting on the relative mispricing, not the market direction. If interest rates rise, an investor would expect to pay less than the bond's face value to obtain a market-equivalent yield.
Step-by-step explanation:
If a hedge fund sells 29½-year bonds and buys 30-year bonds, both with nearly identical durations, but the 30-year bonds are selling at a higher yield (or lower price), the position taken by the fund can be termed a market-neutral strategy. This assumes that the yield curve will normalize and the yield discrepancy between the two bonds will disappear as the two bonds converge in duration and risk. This strategy bets on the relative pricing of two assets, rather than on the direction of the market. Moreover, the fund is not necessarily taking a conservative, bullish, or bearish position on the market as a whole, but rather is seeking to profit from a mispricing between two similar bonds.
Considering the change in interest rates, if the prevailing rates increase, it is expected that an investor would pay less than $10,000 for a bond if its coupon rate is below the new prevailing rate. This is to ensure the bond's yield matches the market interest rate.
Bond yields and prices are inversely related. If yields of newly issued 30-year bonds are higher than those of existing 29½-year bonds, it implies that the prices of the newly issued bonds are lower. When interest rates in the market increase, the price of existing bonds tends to decrease, so they yield returns comparable to new bonds issued at the higher current rates.