Canadian Securities Course (CSC) Level 2 Practice Exam

Which type of fixed income investments is less volatile with increased interest rates because they can reinvest maturing investments with high interest?

1. Short-term

2. Medium-term

3. Long-term

4. Junk bonds

The correct answer is: Short-term

Short-term fixed income investments are indeed less volatile in a rising interest rate environment primarily because of their shorter duration. As these investments reach maturity relatively quickly, investors have the opportunity to reinvest their principal at the new, higher interest rates sooner than they would with longer-term investments. This ability to reinvest shortly after maturity means that any rise in interest rates will have a more immediate and beneficial impact on the returns for short-term investments, allowing for more flexibility and less exposure to the price fluctuations that typically affect longer-term bonds. As interest rates increase, the market value of existing longer-term bonds (which were issued at lower rates) tends to fall, creating greater volatility. In contrast, medium-term and long-term fixed income investments are more sensitive to interest rate changes due to their longer duration, making them more volatile in such circumstances. Junk bonds, while they may offer higher potential returns, come with higher credit risk and are not primarily classified by their response to interest rate changes. Overall, short-term fixed income investments provide a balance of lower interest rate risk and the ability to adapt to changing market conditions, making them more attractive when interest rates rise.