CFA Level 1

AAA

Fixed Income Investments - Reinvestment Risk

Reinvestment risk is the risk that the proceeds from the payment of principal and interest, which have to be reinvested at a lower rate than the original investment.

  • Call features affect an investor's reinvestment risk because corporations typically call their bonds in a declining interest rate environment. This allows them to finance their operations at a cheaper rate, but the investor also has to take those proceeds and invest them at lower rates.
  • Amortizing securities have even greater reinvestment risk. Since the investor is receiving both interest and principle payments each month, they have to continue to invest a greater amount of proceeds than with a regular type of bond. Also, the investor is exposed to prepayment risk as rates decline because mortgage and credit card holders can refinance their debt at lower levels.
  • Zero coupon bonds have no reinvestment risk because there are no coupon payments made to the investor. Because of the lower coupon rate, however, zeros expose the investor to a higher interest rate risk.

Because amortizing securities pay part of their principal with regular interest payments, investors receive the maturity value in installments in a current period. Non-amortizing securities make their payment at a later maturity date. If prevailing interest rates are declining, holders of amortizing securities have to reinvest their coupons and portion of principal at a lower rate. Meanwhile, the non-amortizing securities offer the holder some protection by holding the principal payment off until a later date. This enables the non-amortizing holder to maintain a higher rate at a longer period of time and reduces the reinvestment risk for a portion of his or her holdings

Yield Curve Risk
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