Comparing Risks: U.S. Treasury STRIPS, Putable Corporate Bonds, and GNMA Mortgage-Backed Securities

B

Let's analyze the risks associated with each manager's portfolio:

Manager X invests only in U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities). STRIPS are a type of bond that represents the separate interest and principal payments of a Treasury bond. These securities are considered to be virtually risk-free because they are backed by the U.S. government. As a result, the main risk associated with Manager X's portfolio is reinvestment risk.

Reinvestment risk refers to the risk that future cash flows from investments, such as coupon payments, may need to be reinvested at a lower interest rate. In the case of Manager X, since U.S. Treasury STRIPS have fixed interest rates, there is a risk that when the interest payments are received, the available investment options may offer lower rates, leading to a lower yield on reinvested funds. Therefore, statement A, which suggests that Manager X has more reinvestment risk than Manager Z, is likely to be true.

Manager Z invests only in mortgage-backed securities (MBS) guaranteed by GNMA (Government National Mortgage Association). MBS are securities that represent an ownership interest in a pool of mortgage loans. GNMA guarantees the timely payment of principal and interest on these securities. The main risk associated with Manager Z's portfolio is volatility risk.

Volatility risk refers to the potential for the value of an investment to fluctuate significantly in response to market conditions. Mortgage-backed securities can be subject to volatility due to changes in interest rates, prepayment risk, and other factors. Changes in interest rates can impact the market value of mortgage-backed securities, leading to potential price fluctuations. Therefore, statement B, which suggests that Manager Z has more volatility risk than Manager X, is likely to be true.

Manager Y invests only in putable corporate bonds. Putable corporate bonds give the bondholder the right to sell the bond back to the issuer at a specified price before maturity. The main risk associated with Manager Y's portfolio is interest rate risk.

Interest rate risk refers to the risk that changes in interest rates will affect the value of fixed-income securities. When interest rates rise, the value of existing fixed-rate bonds typically decreases, and vice versa. Since Manager Y invests in putable corporate bonds, they are exposed to potential losses if interest rates rise, as the value of the bonds could decline. Therefore, statement C, which suggests that Manager Y has more interest rate risk than Manager X, is likely to be true.

In summary:

• Manager X has more reinvestment risk than Manager Z (Statement A is likely to be true).
• Manager Z has more volatility risk than Manager X (Statement B is likely to be true).
• Manager Y has more interest rate risk than Manager X (Statement C is likely to be true).