The factors that affect the reinvestment risk of a security

If an investor is to realize the required yield on an investment ina coupon bond, then he/she must be able to invest all of the coupon payments atthat same yield as well. This yield is called yield to maturity, which refers to the percentage rate of returnpaid on a bond if the investor buys and holds it to its maturity date. If thecoupon payments arrive when yields are lower, then they can only be invested atlower rates. This is reinvestment risk. It is the risk that proceeds available for reinvestment must be reinvested at alower interest rate than the instrument that generated the proceeds.

Three factors affect this risk:

• Maturity: the yield to maturity measure for long-term coupon bonds tells little about the potential yield that an investor may realize if the bond is held to maturity. The risk that the coupon payments will be reinvested at less than the original yield to maturity is the reinvestment risk. The longer the maturity, the bigger the reinvestment risk.

• Coupon rate: the higher the coupon rate, the larger the size of the cash flows to be reinvested, and the bigger the reinvestment risk. Therefore a zero-coupon bond has zero reinvestment risk if held to maturity, and a premium bond has bigger reinvestment risk than a discount bond.

• Call, prepayment options and amortizing securities: the reinvestment risk is even greater for these kinds of securities. A callable bond has higher reinvestment risk than a standard bond, because it is likely that the cash flows of the callable bond may be received faster due to the call feature. In a declining interest rate environment borrowers will accelerate their prepayments and force the investor to reinvest more proceeds at lower interest rates.