The bonds of Joslin Corp. are currently callable at par value. The bonds mature in eight years and have a coupon of 8%. The yield on the Joslin bonds is 175 basis points over 8-year U.S. Treasury securities, and the Treasury spot yield curve has a normal, rising shape. As yields on bonds comparable to the Joslin bonds decrease, the Joslin bonds will most likely exhibit:
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A. B. C.A
To determine the likely behavior of Joslin Corp.'s bonds as yields on comparable bonds decrease, we need to consider the concepts of convexity, modified duration, and effective duration.
Convexity: Convexity measures the curvature of the price-yield relationship of a bond. A positively convex bond will experience larger price increases when yields decrease compared to the price decreases when yields increase. Conversely, a negatively convex bond will exhibit smaller price increases when yields decrease compared to the price decreases when yields increase.
Modified Duration: Modified duration is a measure of a bond's sensitivity to changes in interest rates. It measures the percentage change in a bond's price for a 1% change in yield. Modified duration is directly related to the bond's price volatility. As modified duration increases, the bond becomes more sensitive to changes in interest rates.
Effective Duration: Effective duration is another measure of a bond's sensitivity to changes in interest rates. However, unlike modified duration, effective duration takes into account the impact of both parallel shifts in the yield curve and changes in the curve's shape. It provides a more accurate estimate of a bond's price sensitivity in different interest rate scenarios.
Given that the Treasury spot yield curve has a normal, rising shape, we can infer the following:
Now, let's analyze the answer choices:
A. Negative Convexity: Negative convexity means that the bond's price will increase less than proportionately when yields decrease. Given that the Joslin bonds are currently callable at par value, they are likely to exhibit negative convexity. Callable bonds have a limited upside potential as the issuer can choose to redeem them at par value, limiting the potential price appreciation when yields decrease.
B. Increasing Modified Duration: Modified duration measures the bond's price sensitivity to changes in yield. As yields on comparable bonds decrease, the price of Joslin Corp.'s bonds is expected to increase. Consequently, the modified duration of the bonds is likely to decrease since the percentage change in price for a given change in yield will be smaller.
C. Increasing Effective Duration: Effective duration considers both parallel shifts in the yield curve and changes in the curve's shape. Given that the Treasury spot yield curve has a normal, rising shape, as yields on comparable bonds decrease, the effective duration of Joslin Corp.'s bonds is expected to increase. This is because the normal, rising shape of the yield curve implies that longer-term bonds are more sensitive to changes in yields.
Based on the information provided, the most likely answer is:
C. Increasing Effective Duration
As yields on comparable bonds decrease, Joslin Corp.'s bonds are expected to exhibit increasing effective duration, reflecting their increased sensitivity to changes in interest rates.