Risks

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

The longer the maturity, the more subject to interest rate risk and inflation risk. Of course, TIPS are not subject to inflation risk. Other long-term securities are very subject to these risks. As we learned in the bond volatility section, long-term, low coupon bonds are very susceptible to interest rate risk. Therefore, STRIPS and Treasury Receipts fall significantly in price when interest rates rise. Inflation and interest rates are very closely tied together. As you learned on the SIE exam, the Federal Reserve works to raise interest rates when inflation rates rise more than expected.

The higher the coupon and more frequent interest payments, the more reinvestment risk applies. When interest rates fall, interest payments begin 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), but the other debt securities discussed in this chapter do not. Mortgage-backed securities are particularly subject to reinvestment risk due to their monthly payments. The more payments to reinvest, the more reinvestment risk.