As we learned in the previous article, coupon paying bonds have reinvestment risk because the investor is expected to invest the cash flows from the bond at the same rate as yield-to-maturity (YTM) to be able to realize the YTM if he holds the bond till maturity.
There are two key characteristics of a bond that influence the quantum of reinvestment risk in the bond. They are the maturity of the bond and the coupon rate. Let’s look at these factors.
Other factors remaining the same, a bond with a higher maturity will have higher reinvestment risk. This is because the interim coupon payments need to be reinvested for a longer period of time to realize the YTM. We can say that it is difficult to rely on YTM for long-term bonds to measure earnings potential especially if the investor wants to hold the bond till maturity.
Bond’s Coupon Rate
Other factors remaining the same, a bond with a higher coupon will have the higher reinvestment risk. This is because higher dollar amount needs to be reinvested to realize the YTM. This again may not always be possible.
What do you think about the reinvestment risk in a zero-coupon bond? A zero-coupon bond actually has no reinvestment risk because there are no interim coupons paid and all the money is in a way reinvested in the bond itself and a final amount is paid. This is true especially if the bond is held till maturity.
Also read: YTM and Reinvestment Risk
Let’s take an example. Consider a $1000 par, 8% coupon 10 year maturity bond, and a $1000 par, 8% coupon and 12 year maturity bond.
- Which bond will have more investment risk? The second bond because they both pay the same coupon but the second bond has higher maturity and therefore higher dependency on reinvestment income.
- What if the first bond is sold at a discount while the second bond is sold at par? Then the first bond will have capital loss and its dependency on reinvestment risk will increase. Depending on at how much discount the bond is selling, the first bond may even have higher reinvestment risk.