"Reinvestment risk means that a bond investor risks having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield. Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate bond reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. There are no payments over the life to reinvest. … The statement, “If an investor anticipates lower reinvestment rates, high coupon bonds should be purchased,” should read, “…low coupon bonds should be purchased…” Again, if an investor expects interest rates to fall, he would want a lower-coupon bond so that he could reinvest the payments and still maintain his expected YTM. … " ------------------------------------------------------------------------------------------------------ This is an explanation given to a question from schweser, the problem I have with this explanation is with the comments on coupon rate, specifically, “Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons” “if an investor expects interest rates to fall, he would want a lower-coupon bond so that he could reinvest the payments and still maintain his expected YTM” How can this be true? Either you have something to reinvest, hence exposing yourself to reinvestment risk, or in the case of zero coupon bond, you have nothing to reinvest so you have no reinvestment risk, regardless of the size of the coupon, you still have to reinvest it at the prevailing market yield, which could be different from the original implied yield on the bond and expose you to reinvestment risk… especially the statement that a lower coupon will allow you to maintain your expected YTM…bond prices are adjusted by market forces so that they’re priced to have YTM at the current market yield (so you have some bonds selling at premium and some at discount depending on their coupon), when interest rate falls, it affects all coupon bonds equally in terms of trying to maintain the original YTM (cos you still have to reinvest your coupon payments at the original YTM to maintain that, but that rate is no longer provided by the market due to the decline), how does a lower coupon bond have a better chance at keeping its expected YTM…by expected, I assumed they meant the original YTM (when you purchase the bond) any thoughts?
I’ll take a shot: The way I see it, the coupon size does matter, if you’re examining two bonds that have the same maturity and ytm (but diff coupons). It means the bond with the bigger coupon should have a smaller capital gain, and the bond with the smaller coupon should have a bigger capital gain, relatively speaking, again assuming same ytm. The bigger capital gain means less reliance on reinvestment to generate the stated ytm… Make sense? I hope I’m somewhere in the ballpark on this one.
liaaba, there was a huge discussion on reinvestment risk about a month ago. you can find it using search function. In short, the higher the amount of money you receive before bond expiration (the higher the coupon), the more you need to worry about figuring out what to do with the money. That is called reinvestment risk.
Look at a 4% and 5% coupon with 4% YTM’s, par value 100. If the reinvestment rates don’t change, you get a coupon in 6 months, one for 2.50, the other for 2, and at the end of a year this will be reinvested and become (2.50*1.04)=2.60 and (2*1.04)=2.08 respectively, assuming a semiannual schedule. But say the YTM had dropped to 3%. Then you would have (2.50*1.03)=2.575, and (2*1.03)=2.06 as your respective reinvested coupons. The difference between the higher coupon reinvestment is 20.25 cents, whereas it is 20 cents for the lower coupon. So the higher coupon lost more reinvestment dollars when the reinvestment rates dropped. I guess this is because a uniform decrease in the rate will have a greater effect on a higher paying coupon, because the rate decrease effects more money overall. I assume that’s what they mean by saying the reinvestment risk is greater for higher coupons.
culley, ya, I just read again in the text about this part, you’re correct about the having to make up for the capital loss (or having a smaller capital gain), which places a bigger focus on the reinvestment income maratikus, I just read that post, it seems like it was primarily talking about the maturity aspect of reinvestment risk, nonetheless, it’s pretty much in line w/ what’s in the book, thanks anyway