Securities Industry Essentials (SIE) ExamUnderstanding Products and Their RisksHard
A client is considering investing in a bond that is currently trading at a premium. The bond has a coupon rate of 5% and a yield to maturity (YTM) of 4.5%. If the client holds the bond to maturity, what income risk are they primarily exposed to?
- APurchasing power risk
- BInterest rate risk
- CCall risk
- DReinvestment risk
Show answer & explanationAnswer & explanation
Correct answer: D. Reinvestment risk
When a bond trading at a premium matures, the investor receives the par value, which is less than what they paid for the bond. The yield to maturity (YTM) accounts for this capital loss. However, reinvestment risk is the concern that when the bond matures, interest rates may be lower, making it difficult to reinvest the principal at a comparable rate, thus reducing future income. This risk is particularly relevant when considering the income generated after the bond matures.
Why the other options are wrong
- A. Purchasing power risk (inflation risk) relates to the erosion of the value of fixed payments over time due to inflation, which is a general risk but not the primary income risk tied to a bond maturing at a premium.
- B. Interest rate risk relates to the sensitivity of a bond's price to changes in interest rates, affecting its market value if sold before maturity, but not directly the income from a bond held to maturity.
- C. Call risk is the risk that a bond will be redeemed by the issuer before maturity, usually when interest rates have fallen, and is not directly tied to a bond maturing at a premium.
Reinvestment Risk
The risk that future interest rates will be lower than current rates, making it difficult to reinvest income or principal payments at a comparable yield.
- Most significant for long-term bonds, especially zero-coupon bonds.
- Affects investors who rely on consistent income streams.
- Becomes relevant when a bond matures or is called.
Memory trick: Reinvesting is Risky when Rates are Really Low.