CP

Reinvestment Rate Risk

As we saw in the preceding section, anincreasein interest rates will hurt bondholders

because it will lead to a decline in the value of a bond portfolio. But can adecreasein in-

terest rates also hurt bondholders? The answer is yes, because if interest rates fall, a

bondholder will probably suffer a reduction in his or her income. For example, con-

sider a retiree who has a portfolio of bonds and lives off the income they produce. The

bonds, on average, have a coupon rate of 10 percent. Now suppose interest rates de-

cline to 5 percent. Many of the bonds will be called, and as calls occur, the bondholder

will have to replace 10 percent bonds with 5 percent bonds. Even bonds that are

not callable will mature, and when they do, they will have to be replaced with lower-

yielding bonds. Thus, our retiree will suffer a reduction of income.

The risk of an income decline due to a drop in interest rates is called reinvest-

ment rate risk,and its importance has been demonstrated to all bondholders in re-

cent years as a result of the sharp drop in rates since the mid-1980s. Reinvestment rate

risk is obviously high on callable bonds. It is also high on short maturity bonds, be-

cause the shorter the maturity of a bond, the fewer the years when the relatively high

old interest rate will be earned, and the sooner the funds will have to be reinvested at

the new low rate. Thus, retirees whose primary holdings are short-term securities,

such as bank CDs and short-term bonds, are hurt badly by a decline in rates, but hold-

ers of long-term bonds continue to enjoy their old high rates.

Comparing Interest Rate and Reinvestment Rate Risk

Note that interest rate risk relates to the valueof the bonds in a portfolio, while rein-

vestment rate risk relates to the incomethe portfolio produces. If you hold long-term

bonds, you will face interest rate risk, that is, the value of your bonds will decline if

interest rates rise, but you will not face much reinvestment rate risk, so your income

will be stable. On the other hand, if you hold short-term bonds, you will not be ex-

posed to much interest rate risk, so the value of your portfolio will be stable, but you

will be exposed to reinvestment rate risk, and your income will fluctuate with changes

in interest rates.

We see, then, that no fixed-rate bond can be considered totally riskless—even most

Treasury bonds are exposed to both interest rate and reinvestment rate risk.^13 One can

minimize interest rate risk by holding short-term bonds, or one can minimize rein-

vestment rate risk by holding long-term bonds, but the actions that lower one type of

risk increase the other. Bond portfolio managers try to balance these two risks, but

some risk generally remains in any bond.

Differentiate between interest rate risk and reinvestment rate risk.

To which type of risk are holders of long-term bonds more exposed? Short-term

bondholders?

Default Risk

Another important risk associated with bonds is default risk. If the issuer defaults, in-

vestors receive less than the promised return on the bond. Therefore, investors need

to assess a bond’s default risk before making a purchase. Recall from Chapter 1 that

Default Risk 169

(^13) Note, though, that indexed Treasury bonds are essentially riskless, but they pay a relatively low real rate.
Also, risks have not disappeared—they are simply transferred from bondholders to taxpayers.

Bonds and Their Valuation 165