Bob is a bond portfolio manager at FX Capital Partners. His fund recently purchased $500 million principal value of 2-year 10% coupon bonds at par value. Assume that the term structure of interest rates is flat.
Under each of the following 3 scenarios, calculate the actual rate of return earned on this bond investment, assuming FX Capital Partners holds the bonds until maturity.
A. Assume the term structure instantaneously shifts (right after his purchase) from 10% to 15%. Compute the new price of the bonds. Assume FX Capital Partners holds the bonds until maturity. Compute the holding period return for the bonds assuming the term structure remains at 15% over the remainder of the holding period.
B. Repeat part A assuming an instantaneous shift from 10% to 5%.
C. Explain the roles of interest rate risk and reinvestment rate risk in this example.