Fixed Income: Reinvestment Risk

A bond exposed to the greatest investment risk is one selling at:

A) Par

B) Discount

C) Premium

Answer: C

I’m confused by this answer. I was thinking the YTM on a bond selling at a discount would have more reinvestment risk since the YTM assumes you’re able to reinvest the coupon at the current yield achieved at the time of purchase.

A bit tired so I apologize in advance if i’m missing something very simple

If the bond is selling at a premium we can assume that it has a higher coupon. Higher coupon payment = higher investment risk.

© probably has some fat coupons compared to (a) and (b).

Doesn’t a bond selling at a discount have a higher yield that a bond selling at a premium? I thought the risk was in the fact that you may not earn the YTM on the discount bond if the coupon isn’t able to be reinvested at the current yield?

Investment risk assumes that you can reinvest the coupon at the current YTM whether the bond is selling at a discount or premium. So in that regard both discount and premium bonds have reinvestment risk. However, as the premium bond is ikely to carry a larger coupon we can use the general rule of larger coupon = greater investment risk.

Someone else might be able to explain better though.

I suspect that the point is that all else being equal (e.g., credit quality, maturity, and so on), two bonds will sell at the same yield; the reason that one sells at a discount while the other sells at a premium is that the former has a lower coupon than the latter.

The characteristics that increase reinvestment risk are:

  • higher coupon
  • more frequent payments
  • amortizing payments (vs. interest only)
  • call/prepayment options

Ah so that makes more sense if they are selling at the same yield, which means a higher coupon for the premium bond. Got it! A little sleep helped clear it up (along with the good explainations!)

Thank you all for replying!!

My pleasure.