Securities Industry Essentials (SIE) ExamUnderstanding Products and Their RisksMedium
A portfolio manager is considering an investment that offers a fixed income stream and a defined maturity date, but they are concerned about the issuer's ability to make timely interest and principal payments. This concern relates to which type of risk?
- AReinvestment Risk
- BInterest Rate Risk
- CCredit Risk
- DInflation Risk
Show answer & explanationAnswer & explanation
Correct answer: C. Credit Risk
The concern about an issuer's ability to make timely interest and principal payments is specifically credit risk, also known as default risk. This risk is inherent in debt securities.
Why the other options are wrong
- A. Reinvestment risk is the risk that future interest payments will be reinvested at lower rates.
- B. Interest rate risk is the risk that changing interest rates will affect bond prices.
- D. Inflation risk is the risk that rising prices will erode purchasing power.
Credit Risk (Default Risk)
The risk that a bond issuer will be unable to make its promised interest payments or repay the principal amount at maturity.
- Higher for lower-rated bonds (junk bonds).
- Lower for government bonds (e.g., U.S. Treasuries).
- Assessed by credit rating agencies (e.g., S&P, Moody's, Fitch).
- Also known as default risk.
Memory trick: Bonds Bring Bad Bets, Beware.