What type of risk may bond funds face if interest rates decline?

The correct response to the question regarding the type of risk that bond funds may face if interest rates decline is prepayment risk. When interest rates fall, existing bondholders may choose to refinance their bonds or pay them off early to benefit from lower yields available in the market. This means that the bond funds could receive their principal back sooner than expected, which could then need to be reinvested in a lower interest rate environment.

As a result, the bond fund faces the challenge of re-investing this principal at reduced rates, which can impact the overall return of the fund adversely. Understanding prepayment risk is crucial for managing a bond fund's portfolio and ensuring that the fund is able to maintain its performance in varying interest rate scenarios.

In contrast, options like market risk, liquidity risk, and inflation risk represent different forms of risk that do not have the same direct connection to a decline in interest rates as prepayment risk does. Market risk relates to general fluctuations in the market that can affect bond prices. Liquidity risk is concerned with the ability to sell the bond without significantly affecting its price. Inflation risk involves the loss of purchasing power due to rising prices, which can affect bond returns but is not directly tied to drops in interest rates.