Why do low coupon bonds change more in price than high coupon bonds?

Answer 1

Reinvestment risk. Low coupon bonds pay you less now than high coupon bonds. These coupons can be reinvested at prevailing market rates.

The concept is "duration". Think of it like a "barbell", where the balance point is the number of years until you recieve all your cash.

Low coupon bonds have larger durations - like Shaquille O'Neal sitting on a see-saw. You get the $1,000 way into the future.

High-coupon bonds have smaller durations - like Mini-Me. You get a lot of coupn payments sooner, and can thus reinvest them elsewhere.

Answer 2

Cash flows way out in the future are more sensitive to interest rate changes than cash flows that are being paid soon. You can convince yourself of this in one of two ways.

1. Mathematically, you can take the first derivative of the Price-Yield function -- which tells you how much the price changes for a small change in yield. You will see that the derivative is bigger when the cash flow comes way off in the future.

2. If you don't like the mathematical approach -- let's try an intuitive one. If you are to receive a million dollar payment tomorrow -- how much is it worth today if the interest rate is 5%? How about at 10%? The answer is that it is worth almost a million dollars no matter what the interest rate is (for reasonable rates). Changing the rate doesn't change the value much. Now think about a flow of one million in ten years. The discount on that money will be considerable -- and will change a lot for a small change in yield.

OK -- now let's look at two bonds that mature on the same date. The one with the higher coupon has a higher percentage of its flows coming earlier. Those flows are less sensitive to changes in yield than the later flows -- the Price changes less.

Note that this statement can't be said with any certainty unless the bonds have the same maturity. A 5% bond that matures in a year is less sensitive to yield changes than a 10% bond that matures in 30 years.

Answer 3

rate of return