214 Part 3 Financial Assets
One way to manage both interest rate and reinvestment rate risk is to buy a
zero coupon Treasury bond with a maturity that matches the investor’s invest-
ment horizon. For example, assume your investment horizon is 10 years. If you
buy a 10-year zero, you will receive a guaranteed payment in 10 years equal to the
bond’s face value.^16 Moreover, as there are no coupons to reinvest, there is no rein-
vestment rate risk. This explains why investors with speci! c goals often invest in
zero coupon bonds.^17
Recall from Chapter 6 that maturity risk premiums are generally positive.
Moreover, a positive maturity risk premium implies that investors, on average, re-
gard longer-term bonds as being riskier than shorter-term bonds. That, in turn,
suggests that the average investor is most concerned with interest rate price risk.
Still, it is appropriate for each investor to consider his or her own situation, to rec-
ognize the risks inherent in bonds with different maturities, and to construct a
portfolio that deals best with the investor’s most relevant risk.(^16) Note that in this example, the 10-year zero technically has a considerable amount of interest rate risk since its
current price is highly sensitive to changes in interest rates. However, the year-to year movements in price should
not be of great concern to an investor with a 10-year horizon. The reason is that the investor knows that
regardless of what happens to interest rates, the bond’s price will still be $1,000 when it matures.
(^17) Two words of caution about zeros are in order. First, as we show in Web Appendix 7A, investors in zeros must
pay taxes each year on their accrued gain in value even though the bonds don’t pay any cash until they mature.
Second, buying a zero coupon with a maturity equal to your investment horizon enables you to lock in a nominal
cash payo! , but the real value of that payment still depends on what happens to in# ation during your investment
horizon. What we need is an in# ation-indexed zero coupon Treasury bond; but to date, no such bond exists.
Also, the fact that maturity risk premiums are positive suggests that most investors have relatively short in-
vestment horizons, or at least worry about short-term changes in their net worth. See Stocks, Bonds, Bills, and In-
" ation: (Valuation Edition) 2008 Yearbook (Chicago: Morningstar, Inc., 2008), which " nds that the maturity risk pre-
mium for long-term bonds has averaged 1.4% over the past 2 years.
SEL
F^ TEST Di# erentiate between interest rate risk and reinvestment rate risk.
To which type of risk are holders of long-term bonds more exposed? short-
term bondholders?
What type of security can be used to minimize both interest rate and
reinvestment rate risk for an investor with a! xed investment horizon?
7-8 DEFAULT RISK
Potential default is another important risk that bondholders face. If the issuer
defaults, investors will receive less than the promised return. Recall from Chapter
6 that the quoted interest rate includes a default risk premium—the higher the
probability of default, the higher the premium and thus the yield to maturity.
Default risk on Treasuries is zero, but this risk is substantial for lower-grade corpo-
rate and municipal bonds.
To illustrate, suppose two bonds have the same promised cash " ows—their
coupon rates, maturities, liquidity, and in" ation exposures are identical; but one
has more default risk than the other. Investors will naturally pay more for the one
with less chance of default. As a result, bonds with higher default risk have higher
market rates: rd! r* # IP # DRP # LP # MRP. If a bond’s default risk changes,
rd and thus the price will be affected. Thus, if the default risk on Allied’s bonds
increases, their price will fall and the yield to maturity (YTM! rd) will increase.