LOS i: Identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities.

Q1. 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.

Q2. 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.

Q3. Which of the following statements about reinvestment risk is least accurate?

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

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

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

Q4. 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 four investment options (all 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 option 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%.

Q5. 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 TRUE? Rombach:

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

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

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

LOS i: Identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities.fficeffice" />

Q1. 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.

Correct answer is A)

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.

Q2. 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.

Correct answer is A)

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.

Q3. Which of the following statements about reinvestment risk is least accurate?

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

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

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

Correct answer is A)

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.

Q4. Silhouette Enterprises must make a balloon loan payment of $ffice:smarttags" />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 four investment options (all 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 option 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%.

Correct answer is A)

Since all the choices are non-callable, the treasurer will prefer a zero-coupon to a coupon bond. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. Although the 3-year coupon bond fulfills the treasurer’s requirement concerning funds for repayment, it does not minimize reinvestment risk.

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 payoff 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.

Q5. 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 TRUE? Rombach:

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

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

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

Correct answer is C)

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.

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