If interest rates fall, a bond issuer may decide to pay off (or "retire") its debt and issue new bonds that pay a lower rate. When this happens, the fund may not be able to reinvest the proceeds in an investment with a high return or yield. This is an example of:
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A. B. C. D.B
The correct answer is C. Interest rate risk in bond funds.
Interest rate risk refers to the potential impact of changes in interest rates on the value of fixed-income securities, such as bonds. When interest rates fall, the value of existing bonds with higher coupon rates increases because they pay a higher yield than newly issued bonds with lower coupon rates. This is because investors are willing to pay a premium to receive the higher yield on the existing bonds.
However, when bond issuers retire their debt and issue new bonds that pay a lower rate, investors in bond funds may face reinvestment risk. Reinvestment risk refers to the risk that the fund may not be able to reinvest the proceeds from the retired bonds in an investment with a high return or yield. This is because the lower interest rates available on new bonds may not provide the same level of income as the retired bonds.
Therefore, in the context of the given scenario, the risk being illustrated is interest rate risk, specifically reinvestment risk. Credit risk and prepayment risk may also be present in bond funds, but they are not the primary risks being illustrated in this scenario. Credit risk refers to the risk of default by the bond issuer, while prepayment risk refers to the risk that the bond issuer will repay the principal amount earlier than expected.
In conclusion, the scenario given in the question is an example of interest rate risk in bond funds, specifically reinvestment risk.