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
Career Education & ResourcesLearn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
ProfessionalsA financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
Career Education & ResourcesRead about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
Career Education & ResourcesLearn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
Career Education & ResourcesThe non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
Career Education & ResourcesLearn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
Your PracticeThese four professional organizations are among the most respected and well known in the industry.
ProfessionalsFind out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
ProfessionalsThe Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
ProfessionalsLearn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
Professionals who help individuals manage their finances by providing ...
Formerly known as the Association for Investment Management and ...
A financial professional who studies various industries and companies, ...
A professional designation given by the CFA Institute (formerly ...
The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>