Reinvestment Risk

Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows
(e.g., coupon payments) at a rate comparable to their current rate of return. Zero-coupon
bonds are the only fixed-income security to have no investment risk since they issue no coupon
payments. Reinvestment risk is the likelihood that an investment's cash flows will earn less in a
new security. Callable bonds are especially vulnerable to reinvestment risk. This is because
callable bonds are typically redeemed when interest rates begin to fall. Upon redeeming the
bonds, the investor will receive the face value, and the issuer has a new opportunity to borrow at
a lower rate. If they are willing to reinvest, the investor will do so receiving a lower rate of
interest. Investors can try to fight reinvestment risk by investing in longer-term securities since
this decreases the frequency at which cash becomes available and needs to be reinvested.
Unfortunately, this also exposes the portfolio to even greater interest rate risk.

Zero-Coupon Bond
A bond's coupon rate is the percentage of its face value payable as interest each year. A bond
with a coupon rate of zero, therefore, is one that pays no interest. However, this does not mean
the bond yields no profit. Instead, a zero-coupon bond generates a return at maturity. Bond
investors look at several factors when assessing the potential profitability of a given bond. The
key factors that influence a bond's profitability are its face value, or par, its coupon rate, and its
selling price.

The par value of a bond is the stated value at issuance, usually $100 or $1,000. The coupon rate
is largely dependent on federal interest rates. This means that, as interest rates go up or down, the
market value of bonds fluctuates depending on if their coupon rates are higher or lower than the
current interest rate. A zero-coupon bond generally has a reduced market price relative to its par
value because the purchaser must maintain ownership of the bond until maturity to turn a profit.
A bond that sells for less than its par value is said to sell at a discount. Zero coupon bonds are
often called discount bonds due to their reduced prices.

While generating income from this type of investment requires a bit more patience than the
bond's interest-bearing counterparts, zero coupon bonds can still be highly lucrative. In addition,
these types of bonds are simple, low-maintenance investment options, enabling investors to plan
for long-term savings goals by investing relatively small sums that grow over a longer period of
time.

Spot Rate
The spot interest rate is the rate of return earned when the investor buys and sells the bond
without collecting coupon payments. This is extremely common for short-term traders
and market makers. The spot interest rate for a zero-coupon bond is calculated as:

Spot Rate= (Face Value/Current Bond Price) ^ (1/Years to Maturity) −1

Even though a zero-coupon bond does not receive interest payments, it still earns implicit
interest. This happens because the bond price will move toward face value as it approaches
maturity. When a bond is bought and sold without making interest payments, this price change is
the spot interest rate earned by the bondholder. The spot rate is calculated by finding the
discount rate that makes the present value (PV) of a zero-coupon bond equal to its price. These
are based on future interest rate assumptions. So, spot rates can use different interest rates for
different years until maturity.