jawz

The reinvestment assumption is less important if the coupon and term to maturity are:

Coupon

Term to Maturity

A) lower longer

B) higher shorter

C) lower shorter

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This question is asking: when is the risk of a bond investor having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield?  Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. Reinvestment risk is important because the yield-to-maturity (YTM) calculation for a bond assumes that the investor can reinvest cash flows at exactly the coupon rate. (Note: YTM calculations are discussed in a later LOS.)
All else equal, the bond with the shorter term to maturity is less sensitive to changes in interest rates and prepayment rates. Here, this means that a shorter-term bond has lower reinvestment risk than a longer-term bond.  
All else equal, a lower coupon rate means that it is more likely that the investor can reinvest the coupon cash flow at near or equal to the yield-to-maturity. Here, this means that a lower coupon bond has less reinvestment risk.
In summary, reinvestment risk is least important with the combination of shorter maturity and lower coupon rate.

jawz

Kyle Barnes, CFA, is meeting his friend, Lita Rombach, about possible bond investments. Rombach is concerned about reinvestment risk. Which of the following statements about Rombach is CORRECT? Rombach:

A) will prefer a noncallable bond to a callable bond.

B) will prefer a higher coupon bond to a lower coupon bond.

C) need only be concerned about reinvestment risk on coupon payments.

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A noncallable bond reduces reinvestment risk by reducing the risk of repayment.
With her primary concern being reinvestment risk, Romach will prefer a lower coupon bond to a higher coupon bond. Reinvestment risk applies to all bond cash flows, not just the coupon payments.

jawz

Silhouette Enterprises must make a balloon loan payment of $1,000,000 in 3 years. The firm’s treasurer wants to purchase a bond that will provide funds for repayment and minimize reinvestment risk. Assume the company has the following three investment alternatives (all zero coupon bonds with face values of $1,000,000). Market rates are at 8.0%. All bonds are noncallable and are otherwise similar except as noted. Which bond best meets the treasurer’s requirements?

A) A 3-year, zero coupon bond priced to yield 8.0%.

B) A 4-year, zero coupon bond priced to yield 8.5%.

C) A 2-year, zero-coupon bond priced to yield 9.0%.

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Among the zero-coupon bonds, the one that best matches the loan’s maturity will minimize reinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. If he purchased the 4-year zero-coupon bond, he would have to sell the bond prior to maturity to pay off the loan and would face price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, the bond matures one year before the loan is due and would expose the firm to reinvestment risk.

jawz

Which of the following statements about reinvestment risk is least accurate?

A) A bond's yield calculation assumes that coupon cash flows and principal can be reinvested at the computed yield to maturity.

B) A bond investor can eliminate reinvestment risk by holding a coupon bond until maturity.

C) An investor concerned about reinvestment risk is most concerned with a decrease in interest rates.

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The key word here is coupon bond. While an investor in a fixed-coupon bond can usually eliminate price risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupons exposes the investor to the risk that he will have to invest the coupons at a lower rate, thus negatively impacting his holding period return. An investor can greatly decrease reinvestment risk by holding a zero-coupon, noncallable bond that is not subject to other prepayments (or embedded options). Zero-coupon bonds deliver all cash flows in one lump sum at maturity.
The other statements about bond yield calculations and reinvestment risks are correct.

jawz

An investor holds a 20-year, semi-annual 8.00% coupon Treasury bond issued at par. Market interest rates are currently at 6.50%. The bond is noncallable. A coupon payment is due this week. Which of the following choices best represents the type of risk the investor faces?

A) Reinvestment risk.

B) Prepayment risk.

C) Credit risk.

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Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Here, the investor will likely have to reinvest the coupon at the lower market interest rate, negatively impacting his holding period return.
Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely in a declining interest rate environment because it is cheaper to issue replacement debt. Here, the bond is a Treasury and is noncallable, so the investor can eliminate prepayment risk by holding the bond until maturity. Credit risk is the risk that the issuer will be unable to make coupon or principal payments as scheduled. Any change in the timing of the receipt of cash flows affects the bond’s holding period return. Credit risk is not a concern with Treasury securities.

jawz

The risk that an investor will earn less than the quoted yield-to-maturity on a fixed-coupon bond due to a decrease in interest rates is known as:

A) reinvestment risk.

B) prepayment risk.

C) event risk.

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Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase.
Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. Event risk means that the issuer could face a single event or circumstance that would affect its ability to service/repay the debt. For example, a corporation could suffer an industrial accident.

jawz

When determining credit risk spread, the benchmark security is most likely a(n):

A) AA rated bond.

B) high-yield corporate bond.

C) Treasury bond.

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The credit risk spread is measured in relation to a default-free security. Of the choices above, the security with the least chance of default is the Treasury bond. The AA rated bond is high quality, but not the highest quality (which would have an AAA rating). The high-yield corporate bond is an unlikely candidate for the benchmark security because high yield usually denotes high risk.

jawz

Benjamin Zoeller and Tara McGonigal are preparing for the Level I CFA examination. Zoeller is studying credit spread risk. McGonigal is farther along in her studies, but has forgotten how to determine the default free rate if given the yield on a bond rated BBB+ of 9.50% and a risk premium of 3.00%. What does Zoeller tell her to use for the default free rate?

A) 9.50%.

B) 6.50%.

C) 12.50%.

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The formula for credit spread risk (or the yield on a risky asset) is:
YieldRisky = YieldRF + Risk Premium, where RF = default − free rate.
Rearranging this formula results in: YieldRF = YieldRisky – Risk Premium, or YieldRF = 9.50% – 3.00% = 6.50%.

jawz

Suppose that a corporate bond and a government bond have equivalent characteristics. They both have a coupon rate of 6% paid annually and have two years remaining to maturity. Assuming a flat government term structure of 7% which of the following is a possible price of the corporate bond?

A) 98.19.

B) 101.35.

C) 97.76.

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Since the corporate bond involves credit risk and the government bond doesn't. The corporate bond price has to be less than the government bond price which is computed as follows:
Government Bond Price = 6 / 1.07 + 106 / 1.072 = 98.19

jawz

Which of the following will most likely have the least impact on a corporate bond rating? The:

A) issue's indenture provisions.

B) issuing company's volume of sales.

C) issuing company's debt burden.

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The size of the issuing firm, represented by the amount of sales, will play a role in the financial stability of the firm. However, the other choices, leverage and indenture provisions, are more directly related to the bond’s rating. Smaller firms are not likely to issue bonds and issuers are typically larger firms overall.