If you believe interest rates will fall, which bond type should you buy for potential greater price appreciation?

• A. 10-year zero-coupon bond
• B. 10-year coupon bond
• C. 30-year government bond
• D. Corporate bonds only

Answer: (A)

Duration determines how sensitive a bond’s price is to changes in interest rates. A zero-coupon bond has no interim coupon payments, so all of its value comes from a single payment at maturity. That makes its duration essentially equal to its time to maturity, amplifying how much its price moves when yields change.

Between the options, the 10-year zero-coupon bond will exhibit the greatest percentage price rise for a fall in rates because its entire payoff is concentrated at the 10-year mark with no coupon cash flows to cushion price changes. A coupon bond of the same maturity has cash flows along the way, which lowers its duration and reduces the potential price appreciation. The longer-term government bond and corporate bonds introduce other factors (longer maturity and credit risk, respectively) that can alter price moves, but the pure rate-driven price sensitivity is strongest for the high-duration, zero-coupon case.