COMPARING REINVESTMENT RISK AND INTEREST RATE RISK

Comparing reinvestment risk and interest rate risk and how an investor can protect his or her

portfolio from those risks.

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COMPARING REINVESTMENT RISK AND INTEREST RATE RISK

Comparing reinvestment risk and interest rate risk and how an investor can protect his or

her portfolio from those risks.

www.investinginbonds.com defines risk as the chance that you will lose some or all the

money you invested and for this reason, Leslie Jane Federer Vaaler & James W. Daniel (2009 P.

243) mentioned that investors seek a variety of low-risk growth opportunities. Even though

bonds are considered to be less risky, some risks are associated with them such as interest rate

risk, reinvestment risk and Floating rate risk and default risk. Therefore they are required to have

an in-depth knowledge of stock and bond valuation as this will be of use to them when making

critical decisions regarding which investment is viable for them to invest in. These prevent them

from incurring unnecessary losses due to poor decisions are undertaken by them. The purpose of

this paper is to critically analyze the effects of maturity period on the bond return, the difference

between Reinvestment risk and interest rate risk.

Reinvestment Risk

www. Manning- Napier.com defines reinvestment risk as the risk of investing at low rates

of return, thereby failing to achieve total returns over your investment time frame sufficient to

meet your goals. For instance, if an investor invests in a callable bond security, there is always

higher reinvestment risk since the firm may decide to call back the security at the initial rate then

issue the same bond at a lower rate than the initial one. i.e. If the bond was issued at 8% and

called back at the same rate, but then issues to the market at a lower rate of 4%, the initial

investors may not be willing to invest in such a bond being that it exposes them to higher

reinvestment risk. Therefore; reinvestment risk is considered to be high when the bond duration

is long, and the coupon rate is high. Reinvestment risk also comes as a result of the unexpected

market conditions which may lead to the decrease in the bond’s rate of return. For an investor to
COMPARING REINVESTMENT RISK AND INTEREST RATE RISK

prevent such risks, they are required to invest in non-callable securities with zero coupon rates.

Zero coupon bonds refer to those bonds with a single payment at a fixed maturity date.

Interest rate risk

Victor Macrae (2015) defines interest rate risk as an interest rate development that is

detrimental from the firm’s point of view. This risk arises due to changes in the prevailing

interest rate after a bond is issued. In the bond market, if interest rate increases, the value of a

long-term bond is expected to decrease whereas if it decreases then the value of the bond

increases. For this reason, investors have to know the prevailing market conditions before

making an investment decision. For instance, if firm B has a long-term maturity bond whose

coupon rate is low, then interest rate risk for such an investment is considered to be higher as

compared to a bond with short maturity and high coupon rate. A decline in the interest rate may

also lead to the redemption of callable bonds before their maturity thereby making firms to return

the principle amount that was invested by investors. In this case, an investor can only invest in a

lower interest rate bond.

Conclusion

It is, therefore, important for investors to critically analyze their bond performance in the

market and also take note of the changes that may arise due to variations in the coupon rate and

interest rate as well as consider the bond duration. Bonds with a long-term maturity and lower

coupon rate always have higher interest rate risk whereas those with a long maturity, and the

higher coupon rate is exposed to higher reinvestment risk. For this reason, investment decisions

should be made wisely to generate more returns. It can also be concluded that both reinvestment
COMPARING REINVESTMENT RISK AND INTEREST RATE RISK

risk and interest rate risk are affected by the maturity of the bond and the coupon rate as

mentioned in the financetrain.com/factors-affecting-reinvestment-risk/.

COMPARING REINVESTMENT RISK AND INTEREST RATE RISK

Reference

www. Manning- Napier.com

Vaaler Leslie Jane Federer & Daniel, James W. (2009) Mathematical interest theory 2nd Edition;

Mathematic Association of America

Macrae, Victor (2015) Mastering interest rate risk strategy; A practical guide to managing

corporate finance risk

http://www.investinginbonds.com/learnmore.asp?catid=3&id=383

http://financetrain.com/factors-affecting-reinvestment-risk/