Which type of risk is most significant for bonds? A. Default risk B. Interest rate risk C. Reinvestment rate risk D. Maturity risk | Homework.Study.com (2024)
Risk means the possibility of loss. Bond risk is the type of risk that occurs by losing money upon the investment made on a bond. Interest rate risk, default risk, maturity risk, etc are different types of risk associated with the investment made on the bond.
High-yield or junk bonds typically carry the highest risk among all types of bonds. These bonds are issued by companies or entities with lower credit ratings or creditworthiness, making them more prone to default.
High-yield bonds tend to have lower credit ratings of below BBB- from Standard & Poor's and Fitch, or below Baa3 from Moody's. Junk bonds are more likely to default and have higher price volatility.
U.S. government bonds are guaranteed as to the timely payment of principal and interest; however, these securities are subject to market risk if sold prior to maturity.
Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment: As interest rates rise bond prices fall, and vice versa. This means that the market price of existing bonds drops to offset the more attractive rates of new bond issues.
Default risk, also called default probability, is the probability that a borrower fails to make full and timely payments of principal and interest, according to the terms of the debt security involved. Together with loss severity, default risk is one of the two components of credit risk.
The default risk ratio is defined as free cash flow divided by the combined annual principal payments on all outstanding loans. Free cash flow is equal to net profit plus depreciation minus dividend payments.
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