Final answer:
An investor expecting a decrease in interest rates should consider buying bonds at current higher rates. They can sell these bonds at a higher price if the interest rates drop, thereby gaining a capital return in addition to interest earnings. Understanding bond yields and interest rate risks is crucial for making such investment decisions.
Step-by-step explanation:
If the yield to maturity on a one-year zero-coupon bond is 8% and on a two-year zero-coupon bond is 10%, an investor with a one-year investment horizon expecting a future one-year yield to maturity of 6% should strategically arrange their portfolio.
Investors need to consider potential interest rate risks and how they can impact bond prices. If interest rates are expected to decline—the condition expressed by the expected yield dropping to 6%—the investor could potentially benefit by purchasing bonds at today's higher rates. Upon a decrease in interest rates next year, the investor could then sell the bond at a higher price than its face value, realizing a capital gain.
The concept of bond total return includes interest payments as well as capital gains or losses. When interest rates rise, bonds with lower coupon rates sell for less than their face value. Conversely, when interest rates fall, bonds with higher coupon rates can be sold for more than their face value, as they become more attractive to investors searching for yield.