Accounts & Finance

"a) Investors might choose to buy a bond with a lower coupon rate even when there's another bond available from the same issuer with a higher coupon rate. This seemingly counterintuitive decision can be explained by a concept in finance known as the ""interest rate risk"" or ""price risk.""

When a bond's coupon rate is lower, it means the bond will make smaller interest payments over its lifetime compared to a bond with a higher coupon rate. However, the price of a bond is not solely determined by its coupon rate; it is also influenced by the prevailing market interest rates.

Here's why an investor might choose a bond with a lower coupon rate:

1. Interest Rate Changes: When market interest rates rise, newly issued bonds typically come with higher coupon rates to attract investors. If an investor holds a bond with a lower fixed coupon rate in a rising interest rate environment, their bond may become more valuable to other investors because it offers a higher yield compared to newly issued bonds with lower coupon rates. This can drive up the price of the existing lower coupon bond, allowing the investor to sell it at a premium.

2. Preservation of Principal: Bonds with lower coupon rates often have a lower initial price (or face value). Investors who are more concerned with preserving their principal investment might opt for these lower coupon bonds because they are less sensitive to interest rate fluctuations. When market interest rates rise, the prices of existing bonds with higher coupon rates tend to fall more significantly, potentially leading to losses if the investor needs to sell before maturity."