8. Risks of investing in bonds The higher the risk of a security, the higher its

Question

8. Risks of investing in bonds The higher the risk of a security, the higher its expected return will be. A bond's risk level is reflected in its yield, but understanding the different risks involved when investing in bonds is important. The following graph shows the relationship between interest rates and maturity for three security classes: U.S Treasury securities (USTs), AA-rated corporate bonds, and BBB-rated corporate bonds. Use the dropdown menus to label each security's profile correctly: YIELD [%) 15 12 UST 5 10 15 20 25 30 YEARS TO MATURITY Is the default spread between the corporate bonds and the Treasury securities greater for shorter or longer maturities? O Short-term maturities O Long-term maturities Answer the following question based on your understanding of interest rate risk and reinvestment rate risk. True or False: Assuming all else is equal, long-term securities are exposed to higher interest rate risk than O True O False

Explanation / Answer

- Securities with higher default risk has higher yield. So the top curve represents BBB. Middle curve represents AAA, and lower curve represens UST.

- Long term maurities - Default spread means the difference in the yields of different securities. Long term maturities have more interest rate risk compared to short term maturities due to uncertainty in the rates for longer durations. Higher is the interest rate risk, higher is the securities yield. So long-term securities have higher yields and and longer default spread.

- True - Long term securities have higher uncertainty for longer durations, so the have higher interest rate risk.

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