Canadian Securities Course (CSC) Level 2 Practice Exam

How should investors adjust their fixed income strategy if there is an anticipated increase in interest rates?

1. Extend the term

2. Move into equities

3. Shorten the term

4. Stay invested in current bonds

The correct answer is: Shorten the term

The correct choice is to shorten the term of fixed income investments in anticipation of rising interest rates. When interest rates increase, the prices of existing bonds typically fall, especially those with longer maturities. This is due to the fact that new bonds will likely offer higher yields, making the older, lower-yielding bonds less attractive. By shortening the term, investors can reduce their exposure to interest rate risk. Shorter-term bonds are less sensitive to rate changes, meaning their prices are less likely to be adversely affected when interest rates rise. Furthermore, investors can reinvest in new bonds at higher interest rates more quickly, optimizing their portfolios in a rising rate environment. The other options may not effectively mitigate the risks associated with rising interest rates. For instance, extending the term would increase exposure to interest rate risk, moving into equities may not be suitable for all fixed income investors, and staying invested in current bonds may result in capital losses as their prices decline. Therefore, the most prudent strategy in this scenario is to shorten the term of fixed income investments.