Risks

Other than default risk and liquidity risk, most of the other “normal” bond risks still apply, including interest rate risk, inflation (purchasing power) risk, and reinvestment risk.

The longer the maturity, the more exposed a bond is to interest rate risk and inflation risk. Of course, TIPS are not subject to inflation risk. Other long-term securities are highly exposed to these risks. As we learned in the bond volatility section, long-term, low coupon bonds are very susceptible to interest rate risk. That’s why STRIPS and Treasury Receipts can fall significantly in price when interest rates rise.

Inflation and interest rates are closely linked. As you learned on the SIE exam, the Federal Reserve tends to raise interest rates when inflation rises more than expected.

Reinvestment risk increases when a bond has a higher coupon and makes interest payments more frequently. When interest rates fall, those interest payments may have to be reinvested at lower rates of return.

Zero coupon securities like Treasury bills, STRIPS, and Treasury Receipts avoid reinvestment risk (there’s no interest to reinvest). However, the other debt securities discussed in this chapter do not. Mortgage-backed securities are particularly subject to reinvestment risk because they make monthly payments. In general, the more payments you have to reinvest, the more reinvestment risk you have.