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Difficulty: MediumSystematic and Market Risks

An investor seeking capital preservation allocates their entire portfolio into 30-year U.S. Treasury bonds paying a fixed annual coupon of 3%3\%. Over a ten-year holding period, the broader economy experiences a sustained period of unexpected inflation averaging 5%5\% per year. Although the U.S. government makes all scheduled interest and principal payments on time, the investor notices that the goods and services their income can purchase have significantly decreased. Which type of systematic risk has primarily impacted this portfolio?

  1. Purchasing power risk, because inflation erodes the real value of fixed income payments regardless of the issuer's creditworthiness.Answer
  2. B
    Credit risk, because the loss of real value reflects a default by the issuer to adjust payments for macroeconomic changes.
  3. C
    Nonsystematic risk, because the decline in real purchasing power could have been eliminated by diversifying across multiple bond issuers.
  4. D
    Liquidity risk, because the real purchasing power loss is directly caused by an inverted yield curve restricting secondary market trading.

Answer

Purchasing power risk, because inflation erodes the real value of fixed income payments regardless of the issuer's creditworthiness.
The correct answer identifies purchasing power (inflation) risk as the primary systematic factor. When inflation (5%5\%) exceeds a bond's fixed interest rate (3%3\%), the real rate of return becomes negative. Because inflation is a broad macroeconomic force affecting the entire economy, it is systematic and affects fixed-rate bonds regardless of how high the issuer's credit rating is.

Step-by-Step Solution

1
Identify the risk driver described in the scenario.
The investor receives fixed 3%3\% coupon payments while annual inflation averages 5%5\%, causing a gap between nominal yield and price level growth.
When inflation exceeds the fixed return of a bond, the investor experiences a loss of real purchasing power.
2
Classify the risk as systematic or nonsystematic.
Inflation affects the economy as a whole and impacts all fixed-rate securities, making it a systematic risk.
Systematic risks stem from macro-level economic factors and cannot be eliminated simply by diversifying across different bond issuers.
3
Select the specific risk subtype that matches the erosion of real return.
Purchasing power risk (inflation risk) specifically describes the vulnerability of fixed returns to rising consumer prices.
Even backed by the full faith and credit of the U.S. government (zero credit risk), fixed cash flows remain exposed to inflation.

Key Concept

Purchasing power (inflation) risk is a major systematic risk affecting fixed-income instruments, where rising price levels diminish the real buying power of fixed returns regardless of credit safety.
Estimated Time:1m 15s
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Topics

Systematic and Market Risks

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