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Question

Difficulty: EasyGovernment, Municipal, and Corporate Bonds

An investor purchasing a U.S. Treasury bond is concerned that the secondary market value of the security will decline if market interest rates increase prior to maturity. Which of the following risks is the investor primarily exposed to in this scenario?

  1. Interest rate riskAnswer
  2. B
    Default risk
  3. C
    Reinvestment risk
  4. D
    Legislative tax risk

Answer

Interest rate risk
Because U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, default risk is negligible. However, fixed-income market prices move inversely with prevailing interest rates. When interest rates rise, the secondary market price of outstanding bonds falls, exposing the investor to interest rate risk.

Step-by-Step Solution

1
Identify the credit quality and backing of the debt security
U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, making default risk minimal to non-existent.
Understanding the issuer helps rule out credit-related risks.
2
Evaluate the relationship between market interest rates and bond prices
Bond prices and interest rates move in opposite directions (inverse relationship). As market interest rates rise, existing bonds with lower coupons become less attractive, causing their price to fall.
This price sensitivity to interest rate movements defines market/interest rate risk.

Key Concept

Distinction between Interest Rate Risk and Credit Risk in Government Debt Securities
Estimated Time:45s
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Topics

Government, Municipal, and Corporate Bonds

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