Fixed Income Investments - Importance of Reinvestment Income and Reinvestment Risk
Reinvestment income can make up a large portion of the return for a bond. Before beginning with calculations, it is important to understand the difference between total future dollars, which is equal to all the dollars an investor expects to receive and the total dollar return, which is equal to the dollars the investor will realize from the three sources of income for a bond (coupon payment, capital gain/loss, and reinvestment income)
Example: Reinvestment Income
Let's look at an investor that has $96 to invest in a certificate of deposit (CD) that will mature in five years. The bank will pay 3% every six months, which equals a bond equivalent basis of 6%. The total future value of this investment today would be:
96 x (1.03) to the tenth power = $129.02
So the investment of $96 for five years at 6% on a BEY will generate $129.02
To further break it down:
Total Future Dollars = 129.02
Return of Principal = 96.00
Total interest = 33.02
Now let's turn to a bond that has a price of $96, five-year maturity and with a coupon of 5% and YTM of 6%. As shown above an investor must generate $129.02 to provide a yield of 6% or the total dollar return must be $33.02.
So with this bond, the sources of return are a capital gain of: $4 ($100 - $96) and coupon interest of $2.50 for ten periods or $25. That equals $29 without the reinvestment of the coupon payments. As we can see, this leads to a shortfall of $4.02 when compared to the CD example above. This $4.02 can be generated if the coupon payments are invested at a 3% semi-annual rate at the time it is paid.
For the first payment the reinvestment income earned is:
$2.50 x (1.03) to 10 - 1 power - 2.50 = $2.50 x (1.03) to 9th power = $0.76.
If you were to continue this effort, which is unlikely to be required on the exam, you would find the reinvestment income would equal $4.02.
To continue this with the three sources of income would produce the following:
Capital Gain of $4
Coupon Interest of $25
Reinvestment Income or $4.02
The total would be $33.02.
Therefore, reinvestment income accounts for 12% of the total return, illustrating how important reinvestment income can be for an investor.
Factors That Affect Reinvestment Risk
There are two characteristics that affect reinvestment risk:
1. For a given yield to maturity and a given non-zero coupon rate, the longer the maturity, the more the bond's total return depends on reinvestment revenue to realize the yield to maturity at purchase time. Longer maturity = greater reinvestment risk.
2. For a given coupon-paying bond with a given maturity and yield to maturity, the higher the coupon rate, the more the total dollar return depends on the reinvestment of the coupon payments. This must occur in order to produce the yield to maturity at the time of purchase.Spot Rates and Bond Valuation
Bonds & Fixed IncomeReinvestment risk refers to the risk that a bond’s future coupons will have to be reinvested at a lower interest rate.
ProfessionalsCFA Level 1 - Assumptions Underlying Traditional Yield Curve Measures. Learn the two main assumptions underlying yield measures and the limitations of the six different methods of yield.
ProfessionalsCFA Level 1 - Reinvestment Risk. Discover the sources of reinvestment risk and what this means to bond holders. Compares the risk facing amortizing and non-amortizing bonds.
Bonds & Fixed IncomeInvestors base investing decisions and strategies on yield to maturity more so than coupon rates.
Active TradingHere are 5 strategies investors can use to double their investment.
Mutual Funds & ETFsLearn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
ProfessionalsFINRA Series 7 Online Study Guide Section 4 Debt Securities
RetirementFind out why dividend reinvestment may or may not be the right choice for retirees, depending on their financial needs and investment goals.
Bonds & Fixed IncomeIt is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. In this section, we will run ...
Bonds & Fixed IncomeA guide to help to understand the simple math behind fixed-coupon corporate bonds.
The risk that future coupons from a bond will not be reinvested ...
A type of bond that offers investors the option to reinvest coupon ...
The yield of a bond, assuming that you reinvest the coupon (interest ...
The amount of interest that can be earned when money is taken ...
The actual amount of return earned on a security investment over ...
A renewable fixed income security with variable coupon rates ...
Read about some of the basic differences between a debt security's coupon rate and its yield to maturity, and learn which ... Read Answer >>
Find out how to calculate the yield to maturity for a zero coupon bond, and see why this calculation is more simple than ... Read Answer >>
Determining various the various yields that callable bonds can provide investors is an important factor in the bond purchasing ... Read Answer >>
Learn about the difference between a bond's coupon rate and its yield to maturity, and how the par value, coupon rate and ... Read Answer >>
Learn about the difference between a bond's coupon rate and its yield rate, how the coupon rate influences market price and ... Read Answer >>
Find out how a bond's coupon rate influences its price, including the role of government-dictated interest rates and the ... Read Answer >>