Advanced Diploma of Financial Planning (ADFP) Practice Test

Which of the following statements about bonds with longer terms is accurate?

1. They are more sensitive to interest rate changes

2. They exhibit less volatility compared to shorter-term bonds

3. They generate higher yields consistently

4. They do not offer predictable cash flows

The correct answer is: They exhibit less volatility compared to shorter-term bonds

The accurate statement regarding bonds with longer terms is that they are more sensitive to interest rate changes. Longer-term bonds generally have a greater duration, which makes their prices more susceptible to fluctuations in interest rates. This sensitivity arises because when interest rates rise, the present value of the future cash flows that longer-term bonds provide decreases more substantially than that of shorter-term bonds. While it is often perceived that longer-term bonds can provide higher yields, this is not consistently true as it can depend on the prevailing economic conditions and the bond issuer's creditworthiness. Therefore, saying they generate higher yields consistently is an oversimplification. Moreover, longer-term bonds do offer predictable cash flows since they pay interest at regular intervals and return the principal at maturity, which is a key feature of fixed-income securities. The assertion of less volatility in longer-term bonds is also inaccurate because they typically exhibit more price volatility compared to shorter-term bonds due to their increased sensitivity to interest rate risks.