Final answer:
An inflation-indexed bond is the most suitable for avoiding interest rate risk, particularly the risk of inflation. It adjusts the return on the bond with inflation rates, which protects the investor's purchasing power over time, making it an ideal investment for those concerned with long-term financial planning against inflation.
Step-by-step explanation:
The question asks which prefunded bond is most suitable for avoiding interest rate risk. Among the options, the inflation-indexed bond is most suitable for this purpose. Inflation-indexed bonds, like the ones offered by the U.S. government since 1996, provide a rate of return that adjusts with inflation, ensuring that investors receive a real rate of return that is not eroded by inflation, making them a comfort for long-term investors such as retirees.
While a zero-coupon bond is not directly linked to interest rate changes, it does not offer protection against inflation. A floating-rate bond has payments that adjust with market rates, which can provide some cushion against interest rate risk, but again not specifically against inflation. A callable bond gives the issuer the right to redeem the bond before its maturity, which can be disadvantageous for an investor during periods of declining interest rates.
Therefore, for avoiding interest rate risk due to inflation, inflation-indexed bonds are the best option, as they provide a hedge against inflation, ensuring that the return keeps pace with inflationary changes in the economy.