Two analysts have been asked to submit brief summaries to their supervisor on various risks related to bond investing. Included in these summaries were the following statements from each analyst:
Analyst A:In a decreasing interest rate environment, both callable and amortizing securities will experience the negative effects of price compression.
Analyst B:The reinvestment risk of a portfolio can be reduced by replacing zero coupon securities with shorter maturity, amortizing securities such as early tranches of a CMO.
Identify whether the statements of each analyst are correct or incorrect.
Click on the arrows to vote for the correct answer
A. B. C.A
Let's analyze the statements of each analyst and determine whether they are correct or incorrect.
Analyst A's statement: "In a decreasing interest rate environment, both callable and amortizing securities will experience the negative effects of price compression."
This statement is correct. When interest rates decrease, the value of existing fixed-rate bonds tends to increase. However, callable securities (bonds that can be redeemed by the issuer before the maturity date) and amortizing securities (securities that have regular principal payments) can experience price compression.
Callable securities become less valuable to investors when interest rates decrease because issuers are more likely to redeem the bonds and refinance at lower interest rates. This reduces the potential future cash flows for bondholders, which can lead to a decrease in price.
Amortizing securities also face price compression in a decreasing interest rate environment because the periodic principal payments they make become more valuable. As interest rates decrease, the discount rate used to value these future principal payments decreases, leading to higher present values. Consequently, the bond's price increases, which compresses the yield and may reduce potential returns for investors.
Therefore, Analyst A's statement is correct.
Analyst B's statement: "The reinvestment risk of a portfolio can be reduced by replacing zero coupon securities with shorter maturity, amortizing securities such as early tranches of a CMO."
This statement is also correct. Reinvestment risk refers to the risk that cash flows generated from an investment cannot be reinvested at the same rate of return as the original investment. Zero coupon securities, which do not pay periodic interest payments but are sold at a discount and mature at face value, are particularly exposed to reinvestment risk.
By replacing zero coupon securities with shorter maturity, amortizing securities, such as early tranches of a Collateralized Mortgage Obligation (CMO), the investor receives regular principal payments. These principal payments can be reinvested at prevailing market interest rates, reducing the reinvestment risk.
Since Analyst B's statement is also correct, the correct answer is C. Both analysts are correct.