Chapter 7 Bonds and Their Valuation 2137-7b Reinvestment Rate Risk
As we saw in the preceding section, an increase in interest rates hurts bondholders
because it leads to a decline in the current value of a bond portfolio. But can a
decrease in interest rates also hurt bondholders? Actually, the answer is yes because
if interest rates fall, long-term investors will suffer a reduction in income. For
example, consider a retiree who has a bond portfolio and lives off the income it
produces. The bonds in the portfolio, on average, have coupon rates of 10%. Now
suppose interest rates decline to 5%. Many of the bonds will mature or be called;
as this occurs, the bondholder will have to replace 10% bonds with 5% bonds.
Thus, the retiree will suffer a reduction of income.
The risk of an income decline due to a drop in interest rates is called
reinvestment rate risk, and its importance has been demonstrated to all bond-
holders in recent 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-
term bonds because the shorter the bond’s maturity, the fewer the years before the
relatively high old-coupon bonds will be replaced with the new low-coupon is-
sues. Thus, retirees whose primary holdings are short-term bonds or other debt
securities will be hurt badly by a decline in rates, but holders of noncallable long-
term bonds will continue to enjoy the old high rates.
7-7c Comparing Interest Rate and
Reinvestment Rate Risk
Note that interest rate risk relates to the current market value of the bond portfolio,
while reinvestment rate risk relates to the income the portfolio produces. If you
hold long-term bonds, you will face signi! cant interest rate price risk because the
value of your portfolio will decline if interest rates rise, but you will not face much
reinvestment rate risk because your income will be stable. On the other hand, if
you hold short-term bonds, you will not be exposed to much interest rate price
risk, but you will be exposed to signi! cant reinvestment rate risk.
Which type of risk is “more relevant” to a given investor depends critically on
how long the investor plans to hold the bonds—this is often referred to as his or
her investment horizon. To illustrate, consider an investor who has a relatively
short 1-year investment horizon—say, the investor plans to go to graduate school
a year from now and needs money for tuition and expenses. Reinvestment rate
risk is of minimal concern to this investor because there is little time for reinvest-
ment. The investor could eliminate interest rate risk by buying a 1-year Treasury
security since he would be assured of receiving the face value of the bond 1 year
from now (the investment horizon). However, if this investor were to buy a long-
term Treasury security, he would bear a considerable amount of interest rate risk
because, as we have seen, long-term bond prices decline when interest rates rise.
Consequently, investors with shorter investment horizons should view long-term
bonds as being more risky than short-term bonds.
By contrast, the reinvestment risk inherent in short-term bonds is especially
relevant to investors with longer investment horizons. Consider a retiree who
is living on income from her portfolio. If this investor buys 1-year bonds, she
will have to “roll them over” every year; and if rates fall, her income in subse-
quent years will likewise decline. A younger couple saving for their retirement
or their children’s college costs, for example, would be affected similarly be-
cause if they buy short-term bonds, they too will have to roll over their portfo-
lio at possibly much lower rates. Since there is uncertainty today about the
rates that will be earned on these reinvested cash " ows, long-term investors
should be especially concerned about the reinvestment rate risk inherent in
short-term bonds.
Reinvestment Rate Risk
The risk that a decline in
interest rates will lead to a
decline in income from a
bond portfolio.Reinvestment Rate Risk
The risk that a decline in
interest rates will lead to a
decline in income from a
bond portfolio.Investment Horizon
The period of time an
investor plans to hold a
particular investment.Investment Horizon
The period of time an
investor plans to hold a
particular investment.