First, Macaulay duration does not measure interest rate risk; modified duration, effective duration (and later on, key rate duration and spread duration) measure interest rate risk.
Interest rate risk is simply the risk that the bond’s price will change because interest rates change. As I mentioned, modified duration and effective duration are measures of interest rate risk.
Reinvestment risk is the risk that the amount of interest you earn when you reinvest your cash flows will change (because of a change in the interest rate at which you can reinvest the cash flows).
The factors that affect interest rate risk are:
Time to Maturity: the longer the time to the maturity of a bond, the higher the interest rate risk
Coupon Rate: the lower the coupon rate, the higher the interest rate risk
Yield to Maturity: the lower the yield to maturity, (generally) the higher the interest rate risk (the exception being that callable or prepayable bonds have low interest rate risk at low yields to maturity)
Amortization: nonamortizing bonds have higher interest rate risk than amortizing bonds
The factors that affect reinvestment risk are:
Time to Maturity: the longer the time to the maturity of a bond, the higher the reinvestment risk
Coupon Rate: the higher the coupon rate, the higher the reinvestment risk
Coupon Frequency: the more frequent the coupon payments, the higher the reinvestment risk
Amortization: amortizing bonds have higher reinvestment risk than nonamortizing bonds
I haven’t had a chance to write an article on the risks of fixed income investments. I should get to it by next week.
S2000, I couldn’t get the point of how amortization affect interest rate risk & reinvestment risk. Is nonamortizing bonds mean par bonds, and amortizing bonds mean premium/ discount bonds. Could you pls explain this?
Thank much
"Amortization: nonamortizing bonds have higher interest rate risk than amortizing bonds
Amortization: amortizing bonds have higher reinvestment risk than nonamortizing bonds"
Amortizing bonds have payments that comprise principle and interest, such as MBSs and ABSs. Nonamortizing bonds have payments that are interest only, then the principle is paid at the end.
Amortizing bonds will have higher periodic payments, reducing the duration and increasing the amount to reinvest.
Thanks S2000- This helps a lot. Always appreciated.
One other question for you -
Schweser explains that the Mac Duration is the point at which the market price risk equals reinvestment risk. For example if the Mac Duration is 8. This is the point at which market price risk and reinvestment risk are equal.
Can you explain why earlier on in the investment horizon, market price risk outweighs the reinvestment risk?
Is the market price risk, the same thing as interest rate risk?
Yes, one of the interesting characteristics of Macaulay duration is that it gives the point of indifference: if interest rates change and the Macaulay duration is, say, 8 years, then 8 years after the interest rate change, the portfolio value (value of the bond plus the value of the coupons with reinvested interest) is the same as it would have been had interest rates not changed.
If your holding period is _ shorter _ than the Macaulay duration, then you’ll lose more on the value of the bond than you’ll gain via the additional interest from reinvesting the coupons. If your holding period is _ longer _ than the Macaulay duration, then you’ll gain more via the additional interest from reinvesting the coupons than you lose on the value of the bond.
Yes.
You’re quite welcome. I look forward to writing it.
Time to Maturity: the longer the time to the maturity of a bond, the higher the interest rate risk
It is not a case for bonds with coupon rate less than their YTM, please see picture. There is a range where bonds with longer maturities have less MD (and interest risk accordingly) than their shorter counterparts.
