Which of the following has more interest risk? Why?
A. Bond A with a 10% Coupon and a YTM of 10% which matures in 5 years.
B. Bond B with a 10% Coupon and a YTM of 10% which matures in 11 years.
C.) A share of Preferred Stock that pays $10 dividend in perpetuity with a required rate of 10%
***i know B is more risk than A but I'm stuck between B and C and I also need an explanation of why...thanks
To determine which investment option has more interest risk between Bond B and the preferred stock, we need to consider the concept of maturity and the potential changes in interest rates.
Bond B with a 10% coupon and a YTM (yield to maturity) of 10% that matures in 11 years carries more interest risk compared to Bond A. This is because it has a longer maturity period, meaning it will be exposed to the fluctuation of interest rates for a longer duration. If interest rates were to increase, the value of Bond B would decrease more than that of Bond A, causing greater potential losses.
When considering the preferred stock, it pays a fixed dividend of $10 perpetually and has a required rate of return (discount rate) of 10%. This means that as long as the company remains solvent and the preferred stock exists, the dividend payment of $10 will remain constant. However, it is essential to note that preferred stock does not have a maturity date like bonds.
In terms of interest risk, the preferred stock is generally considered less risky than the bond because it does not have the same sensitivity to changes in interest rates. The value of preferred stock is primarily driven by factors other than interest rates, such as the financial health of the issuer and the demand for the preferred stock itself.
While the bond's value is affected by changes in interest rates, the preferred stock's value is influenced by factors unique to equity investments, such as the company's performance, profitability, and investor sentiment. Therefore, in this scenario, Bond B with a longer maturity period faces more interest risk compared to the preferred stock.