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Question

Difficulty: EasyGovernment, Municipal, and Corporate Bonds

An investor purchases a newly issued 30-year U.S. Treasury bond paying a fixed coupon rate. Which of the following risks presents the primary threat to the market value of this bond prior to its maturity if market interest rates increase?

  1. Interest rate riskAnswer
  2. B
    Default risk
  3. C
    Out-of-state tax exemption risk
  4. D
    Systematic risk elimination

Answer

Interest rate risk is the primary risk facing long-term Treasury bondholders, as rising prevailing rates drive down existing bond market prices.
U.S. Treasury securities carry virtually zero credit or default risk due to government backing. However, because bond prices move inversely to interest rates, holding a long-term 30-year fixed-coupon bond exposes the investor significantly to interest rate risk when prevailing market yields rise.

Step-by-Step Solution

1
Assess the credit profile of the security.
Because U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, credit and default risk are negligible.
The U.S. federal government has the authority to tax and print currency to meet debt obligations.
2
Analyze market price sensitivity to interest rate movements.
Bond prices and market interest rates share an inverse relationship. Longer-term bonds exhibit greater price drop sensitivity when interest rates rise.
Fixed coupon payments become less attractive when new issues offer higher current yields, causing existing bond values to drop.

Key Concept

Interest Rate Risk vs. Credit Risk in U.S. Treasury Debt
Estimated Time:45s
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Topics

Government, Municipal, and Corporate Bonds

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