SIE Ready⚠️ Investment Risks · Lesson 2 of 5 · 6 min
Rates Up, Prices Down: Rate, Inflation and Reinvestment Risk
📈 Rates rise and a perfectly safe Treasury bond can still lose market value. Safe from default is not the same as safe from price swings.
💡 Key idea
Long and low swing the most: longer maturities and lower coupons have the greatest interest rate risk. Inflation erodes fixed payments.
🧠 Why it matters
INTEREST RATE RISK: when market rates rise, prices of existing fixed-rate bonds (and fixed-dividend preferred) fall, because new issues pay more. Price sensitivity is greatest for LONG maturities and LOW coupons. Holding to maturity avoids the price loss, since par is repaid; selling early does not. Even U.S. Treasuries carry this risk. PURCHASING POWER (INFLATION) RISK: inflation erodes what fixed payments buy, so it hurts fixed-income and cash-like holdings the most; it is the classic risk of "playing it too safe." REINVESTMENT RISK: when rates fall, interest and principal received must be reinvested at lower rates. Zero-coupon bonds have no coupons to reinvest, so they avoid reinvestment risk but carry the most interest rate risk.
📈 In the real world
🏦 Mr. Osei keeps his savings in a long-term, low-coupon bond fund because "bonds are safe." Rates jump two points and the fund's value drops sharply. Meanwhile his sister, who keeps everything in a savings account paying less than inflation, is losing purchasing power every year. Each picked a different risk, not zero risk.
📌 Takeaways
- Rates up = fixed-rate bond prices down; long and low coupon swing most
- Inflation (purchasing power) risk hits fixed payments and cash
- Falling rates create reinvestment risk; zero-coupon bonds avoid it
📖 Terms in this lesson
Interest rate risk: The risk that rising rates push down prices of existing bonds, greatest for long maturities and low coupons.
Inflation risk: The risk that rising prices erode what an investment's returns can buy, worst for fixed payments.
Reinvestment risk: The risk that interest or returned principal must be reinvested at lower rates.
LONG AND LOW SWING MOST: Long maturities and Low coupons make bond prices swing the most when rates move.
✅ Test yourself
Which bond would have the greatest price change if interest rates rise by 1%?
- 5-year bond with a 6% coupon
- 25-year bond with a 7% coupon
- 25-year bond with a 3% coupon
- 5-year bond with a 2% coupon
Answer: C · 25-year bond with a 3% coupon
Long maturity and low coupon both increase price sensitivity, so the 25-year 3% bond moves most. The 7% coupon softens the 25-year bond's swing, and both 5-year bonds are much less sensitive.
A retiree's income comes entirely from fixed-rate bonds held to maturity. What is the retiree's greatest long-term risk?
- Purchasing power risk
- Call risk
- Business risk
- Currency risk
Answer: A · Purchasing power risk
Fixed payments buy less as prices rise, so inflation (purchasing power) risk is the main long-term threat. Holding to maturity reduces price risk; nothing suggests foreign bonds; call risk applies only to callable issues.
Which security has no reinvestment risk if held to maturity?
- A zero-coupon bond
- A corporate bond with a 5% coupon
- A Treasury note paying semiannual interest
- A preferred stock paying quarterly dividends
Answer: A · A zero-coupon bond
A zero-coupon bond pays nothing until maturity, so there are no periodic payments to reinvest at lower rates. The other choices all make periodic payments that face reinvestment risk.
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