Which type of bond has the highest interest rate risk according to bond characteristics?

Long-term, low coupon bonds exhibit the highest interest rate risk primarily due to their duration and cash flow characteristics. Interest rate risk is the risk that changes in market interest rates will adversely affect the value of a bond.

When interest rates rise, the price of existing bonds tends to fall. This is more pronounced for bonds with longer maturities because they have cash flows that are further out in time. In the case of long-term bonds, the market value is highly sensitive to interest rate changes due to the extended timeline over which the fixed payments are received. Low coupon bonds have smaller periodic payments compared to their face value, resulting in a larger negative price adjustment when rates rise, as investors will demand a higher yield for their investment in the face of increased rates.

In contrast, short-term bonds have their principal returned to investors sooner, which diminishes the impact of interest rate fluctuations, as they are less affected by what happens in the longer-term market. High coupon bonds also provide larger cash flows sooner, which reduces their sensitivity to rate changes.

Therefore, long-term, low coupon bonds indeed present the greatest risk when it comes to changes in interest rates, making them the correct answer to this question.