If you believe interest rates will fall, which bond should you consider purchasing?

When considering the impact of falling interest rates on bond purchases, a zero-coupon bond is particularly advantageous. Zero-coupon bonds do not pay periodic interest; instead, they are sold at a discount and mature at face value. This means their price appreciates significantly when interest rates decline, as they are more sensitive to changes in interest rates compared to coupon bonds.

In a scenario of falling interest rates, the present value of the future cash flows from a zero-coupon bond increases more than for bonds that pay regular interest. Thus, investors anticipating a decrease in interest rates may see greater capital gains on zero-coupon bonds. They are effectively locked into a higher yield, as the entire return comes at maturity, making them very attractive when rates decline.

While long-term bonds, such as a 30-year treasury bond, may also provide benefits in a falling rate environment, the zero-coupon bond offers a more pronounced effect due to its price sensitivity and lack of interim cash flows. This makes the zero-coupon bond the preferred choice for an investor expecting interest rates to fall.