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CHAPTER 2 - RISKS ASSOCIATED WITH INVESTING IN BONDS > V. REINVESTMENT RISK
V. REINVESTMENT RISK
Reinvestment risk is the risk that the proceeds received from the payment of interest and principal (i.e., scheduled payments, called proceeds, and principal prepayments) that are available for reinvestment must be reinvested at a lower interest rate than the security that generated the proceeds. We already saw how reinvestment risk is present when an investor purchases a callable or principal prepayable bond. When the issuer calls a bond, it is typically done to lower the issuer’s interest expense because interest rates have declined after the bond is issued. The investor faces the problem of having to reinvest the called bond proceeds received from the issuer in a lower interest rate environment.
Reinvestment risk also occurs when an investor purchases a bond and relies on the yield of that bond as a measure of return. We have not yet explained how to compute the “yield” for a bond. When we do, it will be demonstrated that for the yield computed at the time of purchase to be realized, the investor must be able to reinvest any coupon payments at the computed yield. So, for example, if an investor purchases a 20-year bond with a yield of 6%, to realize the yield of 6%, every time a coupon interest payment is made, it is necessary to reinvest the payment at an interest rate of at 6% until maturity. So, it is assumed that the first coupon payment can be reinvested for the next 19.5 years at 6%; the second coupon payment can be reinvest....