Stocks, Bonds, and Interest Rates Summary

Question 1: Volatility of Short-term vs. Long-term Interest Rates

Statement: Short-term interest rates are more volatile than long-term interest rates, so short-term bond prices are more sensitive to interest rate changes than long-term bond prices.

Answer: This statement is true.

Explanation:

Short-term interest rates often experience greater fluctuations due to their sensitivity to changes in monetary policy, economic conditions, and market sentiment. Central banks, such as the Federal Reserve in the United States, frequently adjust short-term interest rates in response to inflation and other economic indicators. This responsiveness can lead to rapid changes in short-term rates.

Because short-term bonds typically have shorter durations, their prices are more sensitive to these fluctuations. The price of a bond is inversely related to interest rates; when interest rates rise, bond prices fall, and vice versa. Consequently, a small change in short-term interest rates can lead to a more significant percentage change in the price of short-term bonds compared to long-term bonds.

Long-term interest rates, while still affected by monetary policy and economic conditions, tend to be more stable. They reflect market expectations for future inflation and growth over a longer period, which results in less volatility relative to short-term rates. Therefore, the price sensitivity of short-term bonds makes them more reactive to changes in interest rates compared to long-term bonds.

Question 2: Perpetual Bonds

Question: A bond that pays interest forever and has no maturity date is perpetual, also called perpetuity. In that respect, is a perpetual bond similar to:

– a) A no-growth common stock
– b) A share of preferred stock

Answer: A perpetual bond is more similar to b) a share of preferred stock.

Explanation:

Perpetual bonds and preferred stocks share key characteristics that establish a similarity between the two:

1. Fixed Payments: Both perpetual bonds and preferred stocks provide fixed payments (interest for bonds, dividends for preferred stocks) that are paid indefinitely. This means that the cash flows from both instruments do not have an expiration date.

2. Priority in Liquidation: In the event of a company’s liquidation, preferred stockholders and bondholders typically have priority over common stockholders. However, preferred stock is subordinate to debt holders in terms of claims on assets.

3. No Maturity: Perpetual bonds do not mature, which means there is no capital return at a specific point in time. Similarly, preferred stocks do not have a maturity date and continue to pay dividends as long as the company remains solvent.

On the other hand, a no-growth common stock represents an ownership stake in a company without a guaranteed return or fixed dividend payments. Common stockholders benefit from potential capital appreciation and may receive dividends, but these are not guaranteed and can fluctuate based on company performance.

In conclusion, while no-growth common stocks have some similarities with perpetuities (in terms of indefinite ownership), they differ fundamentally in their cash flow structure compared to perpetual bonds and preferred stocks, which both provide fixed returns indefinitely.