Reducing Reinvestment Risk: Optimal Bond Selection for Portfolio Management

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To determine the most appropriate choice for Richard Wallace's portfolio to reduce reinvestment risk, let's analyze each option and assess its characteristics:

A. Mortgage-Backed Security (MBS) with Scheduled Principal and Interest Payments: MBS refers to a bond backed by a pool of mortgage loans. In this case, the MBS has scheduled principal and interest payments. This means that the bondholder will receive regular payments of both principal and interest over time. By having scheduled payments, reinvestment risk is reduced because the bondholder can expect a consistent cash flow stream. Therefore, this option can be considered a good choice for reducing reinvestment risk.

B. 8%, 10-Year Treasury Bond with Semiannual Payments: This option represents a Treasury bond with an 8% coupon rate and a maturity of 10 years. It pays interest semiannually. While Treasury bonds are generally considered low-risk investments, this particular bond does not explicitly address reinvestment risk. The semiannual payments can be reinvested, but there is no assurance that the interest rates prevailing at the time of reinvestment will be favorable. Therefore, this option does not directly mitigate reinvestment risk as effectively as the scheduled payments in option A.

C. 15-Year Treasury Strip: A Treasury strip is a type of zero-coupon bond that represents the future cash flows of a Treasury security. It does not make periodic interest or principal payments. In this case, the strip has a maturity of 15 years. Since there are no regular payments, the reinvestment risk is higher compared to options with scheduled payments. The investor would receive a lump sum payment at the bond's maturity date. Although Treasury strips are considered low-risk investments, they do not offer consistent cash flows to reduce reinvestment risk. Therefore, this option is not the most appropriate choice for reducing reinvestment risk.

Considering the above analysis, option A, a mortgage-backed security with scheduled principal and interest payments, is the most appropriate choice for Richard Wallace's portfolio to reduce reinvestment risk. The scheduled payments provide a consistent cash flow stream, which mitigates the risk associated with reinvesting the received funds.