Sarah considers two bonds: Bond A has a modified duration of 5 years, and Bond B has a modified duration of 8 years. Both bonds have the same credit quality and yield. If interest rates are expected to fall significantly, which bond would generally be preferred by Sarah seeking higher capital appreciation and why?

Question: Sarah considers two bonds: Bond A has a modified duration of 5 years, and Bond B has a modified duration of 8 years. Both bonds have the same credit quality and yield. If interest rates are expected to fall significantly, which bond would generally be preferred by Sarah seeking higher capital appreciation and why?

Answer options:

• Bond A, because it has lower interest rate sensitivity. ✅ Bond B, because it has higher interest rate sensitivity.
• Bond A, because its price will be less volatile.
• Neither, as duration is irrelevant in a falling interest rate environment.

Correct answer: Bond B, because it has higher interest rate sensitivity.

Explanation: Modified duration measures the price sensitivity of a bond to changes in interest rates. A higher modified duration means the bond's price will change more significantly for a given change in interest rates. If rates are expected to fall, Bond B with a higher duration will experience greater capital appreciation.