Monetary Policy and Investment Opportunities

By Laura S. Nowak | Go to book overview

7
Intermediate- Long-Term Fixed Income Securities

Investors in intermediate-and longer-term fixed income securities face several risks. One is credit risk (the risk that the price of the issue falls due to deteriorating financial abilities of the issuer, which increases the probability that the issuer may be unable to pay either interest or principal or both). This is sometimes called default risk. Another risk faced by investors is interest rate risk (the risk that market interest rates, in general, rise, causing fixed income securities to fall in price). On the other hand, investors also face reinvestment risk (the risk that market interest rates, in general, fall so that opportunities for reinvestment of interest or principal are. lower than expected). Event risk also exists. It is the risk that some "event" occurs and lowers the market's perception of the value of the security (e.g., management discloses plans for a leveraged buyout). Since the firm's debt level will rise, its outstanding bonds will be more risky. Another type of risk is prepayment risk (the risk that some principal is paid back earlier than expected and has to be reinvested under less desirable circumstances). This type of risk is inherent in mortgage pass-through securities. For bonds that are callable, the possibility of being called is also a risk.

In addition to the risks associated with intermediate-and long-term notes and bonds, there are also variations in the form of their cash flows. There are coupon bonds, zero coupon bonds, and floating rate bonds. Most coupon bonds do not actually have coupons anymore. Instead, they are registered and sold in book-entry form, where the holder of record, or his/ her bank, receives the coupon payments on the coupon dates and the full

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