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Negative Duration gap => Duration of Assets < Duration of Liabilities
=> Liabilities are more sensitive than Assets to a given interest rate change
=> If Interest Rates fall, Liabilities gain more value than Assets
=> Reduces the value of the firm’s equity
=> Hence firm is likely to settle/refinance some of its debt while interest rates are low
e.g.: Let’s say Company A (Borrower) issues a 5 year fixed coupoun bond to Investor B (Lender)
If the bond is callable and Interest rates fall in 2-yrs time, it is possible that the borrower may choose to call the bond, repay any remaining interest and principal to the investor, and refinance with a new bond issued at the lower interest rate. This exposes the investor (lender) to the risk of not being able to reinvest remaining coupons at the same higher rate that was prevalent for the first 2-yrs of the bond.
P.S>: I feel there may be a better/smarter way to answer this question; But these are my initial thoughts
Negative duration gap means the assets horizon (Macaulay Duration) is lower than your investment horizon, and thus it will limit your ability to earn interest on the coupon and payment received on the asset going forward because the Assets duration has expired or limited, so you are faced with reinvestment risk.
Hope that helps.
I thought reinvestment risk was the risk of reinvestment of payments at a lower interest rate? Isn’t the risk here have to do with losing out on additional coupon payments, which does not really have to do with reinvestment risk?