If portfolio duration is less than liability duration, portfolio is exposed to reinvestment risk. If interest rates are decreasing, the losses from reinvested coupon and principal payments would more than offset any gains from appreciation in the value of the outstanding bonds.
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I understand when rates are decreasing, the shorter duration portfolio needs to be invested in a lower rates. But why the loss is higher than the gain from the appreciation of the value?
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If the interest rates are increasing, will the gains from reinvested coupon and principal payments would more than offset any loss from appreciation in the value of the outstanding bonds.? If so, do we call it reinvestment benefit then instead of reinvestment risk?
Thank you!
The shorter duration bonds won’t appreciate as much as a longer duration bond when rates drop, thus shorter duration bonds reinvestment risk is higher than the appreciation from a rate drop.
I think that is correct?
Jeff
Just always be careful. I feel like people are always thinking that a bond portfolio is immunizing another bond portfolio --> it’s a liability.
Makes sense that the shorter duration bond has less appreciation. But why is the loss from reinvested coupon and principal bigger than the gain from the appreciation of the bond?
The original question is referring to the investment portfolio though.
I see now. The change in the principal payments is a lot bigger than the coupon part. So, when the interest rate is lower, ignoring the coupon difference, the loss of the principal payment will be higher than the gain from the appreciation in the bond.
If the interest rate is increasing when portfolio duration is less than liability duration, there is no reinvestment risk. We will only have reinvestment risk when the interest rate is decreasing.
Same to price risk. It only occurs when the rate is increasing and the portfolio duration is greater than the liability duration.
Thank you for all your help!
The principal payment on the asset or liability? Liability right?