Comparison of MBS and Callable Corporate Bond Risks

C

The risks that Sharon Foster faces by holding each of these securities can be best described as follows:

1. Mortgage-backed security (MBS): MBS represents a bond that is backed by a pool of mortgage loans. The first bond in Sharon's portfolio is an MBS with a coupon rate well above current market rates for securities with similar characteristics. In this case, the primary risk Sharon faces is interest rate risk.

Interest rate risk: When interest rates rise, the value of fixed-rate bonds, such as the MBS, tends to decrease. This is because new bonds issued with higher coupon rates become available, making existing bonds with lower coupon rates less attractive to investors. Consequently, the market value of the MBS may decline. Therefore, Sharon faces interest rate risk with the MBS, as changes in interest rates can affect the value of the bond.

2. Callable corporate bond: The second bond in Sharon's portfolio is a callable corporate bond with five years to maturity and a coupon rate of 9%. Callable bonds give the issuer the option to redeem the bond before the maturity date. In this case, the bond is nonrefundable, which means the issuer cannot call back the bond.

Call risk: The primary risk Sharon faces with the callable corporate bond is call risk. Call risk refers to the possibility that the issuer may decide to call back the bond before its maturity date. If interest rates decline after the issuance of the bond, the issuer may choose to call back the bond and refinance it at a lower interest rate. This would leave the investor with the reinvestment of the principal at a potentially lower interest rate.

Therefore, the risks that Sharon faces by holding each of these securities can be best described as: A. Interest rate risk for the MBS, and call risk for the corporate bond.