Question

As a portfolio manager for an insurance company, you are about to invest funds in one of three possible investments: a) 10-year coupon bonds issued by the U.S. Treasury, b) 20-year zero-coupon bonds issued by the Treasury, or c)One-year Treasury securities. Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon will be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly.

a. If your expectations are correct, how will the return of each investment be affected over the one-year horizon?
b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon and why?
C. Offer possible reasons you might not select the investment that would have the highest
expected return over the one-year investment horizon.

Answer 1

If inflation declines, long-term bonds such as 20-year zero-coupon bonds would likely see the highest return due to their sensitivity to interest rate changes. Short-term one-year Treasury securities would be least affected. Preferences for other investments could be driven by liquidity needs or other factors not tied to the anticipated rate of return.

Step-by-step explanation:

When considering which investment to choose—10-year coupon bonds, 20-year zero-coupon bonds, or one-year Treasury securities—under the expectation that the U.S. inflation rate will decline substantially, it is important to understand how each investment responds to interest rate changes. As interest rates and inflation rates are inversely related, a decline in inflation suggests a potential decrease in interest rates, consequently affecting bond prices.

10-year coupon bonds and 20-year zero-coupon bonds are sensitive to changes in interest rates and would increase in value if interest rates fall as expected with the decrease in inflation. The 20-year zero-coupon bonds, having a longer duration, would be more affected by the interest rate change and hence are likely to see a greater price increase and return over the one-year horizon. On the other hand, the one-year Treasury securities are less sensitive to interest rate changes due to their short maturity.

Although the 20-year zero-coupon bonds might provide a higher return in this scenario, reasons for not selecting them could include liquidity needs, reinvestment risk, or regulatory requirements that favor shorter-term investments.