Both the 15 year Ginny Mae and 20 year corp debenture are subject to reinvestment risk. And the main idea over the course has been that the longer the maturity the greater the risk. In this question the frequency is factored in. However, a 20 y maturity is still (pretty much) longer than 15. So why is the frequency prevailing in this case? What if the GNMA certificates matured in 10 years instead of 15 and compared to the same 20 year corp debenture?
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Hi @Calm_scarlet_beetle. I think you may be confusing reinvestment risk with interest rate risk.
Debt securities with the longest maturities are most subject to interest rate risk. Reinvestment risk, which occurs when interest payments are reinvested back into the market at lower rates of return, is more focused on two aspects - frequency and the amount of coupon payments. The more frequent the payments and the higher the coupon, the more a security is susceptible to reinvestment risk.
GNMA pass through certificates make monthly payments, which subjects investors to reinvestment risk 12 times a year. Debentures make semi-annual payments, which only subjects investors to reinvestment risk twice a year. Comparing the two together, the GNMA certificates are subject to higher levels of this risk.
STRIPS and Treasury bills don’t pay interest until maturity, and therefore are considered to have no reinvestment risk.
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Should we assume, then, that we have to compare the risk (not just this one) within the same period of time? Then it undoubtedly matters. Because here it’s 15 years vs 20 years. I agree that the reinvestment risk for 15 years of the 15 year security would be higher than for the 20 year, assuming they were both boglught at the same time. However, the extra 5 years of holding the 20 year security may carry additional risks, including reinvestment risk, that make it riskier in general.
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Time definitely plays a factor in determining the amount of reinvestment risk an investor faces. The longer the investment lasts, the more an investor absorbs risk in general. However, you’ll want to approach questions like this focused on the risk at hand. The test writers are aiming to determine if you understand how specific risks affect specific investments.
Going back to the question you referenced, it’s quite clear the debentures would be subject to the most “total risk” as the other 3 securities all have direct backing from the US government. However, the GNMA securities clearly are subject to the most reinvestment risk given the frequency of their payments.
I didn’t answer your question above:
What if the GNMA certificates matured in 10 years instead of 15 and compared to the same 20 year corp debenture?
I would still assume the GNMA securities would be subject to higher levels of reinvestment risk, primarily due to extension risk. Should interest rates rise (like they are now in the real world), the length of mortgage-backed securities will lengthen, meaning they could last years longer than the original expected 10 year time frame. Keep in mind these securities never have a fixed maturity date.
Bottom line - mortgage-backed securities are notorious for their reinvestment risk, so they are commonly going to be the answer in a question like this.
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