Reading 62: Risks Associated with Investing in Bonds-LOS i 习 center, affect, factors, security, 2011

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Session 15: Fixed Income: Basic Concepts
Reading 62: Risks Associated with Investing in Bonds

LOS i: Identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities.

 

 

The risk that an investor will earn less than the quoted yield-to-maturity on a fixed-coupon bond due to a decrease in interest rates is known as:

A) prepayment risk.

B) reinvestment risk.

C) event risk.

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Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase.

Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely to occur in a declining interest rate environment because it is cheaper to issue replacement debt. Event risk means that the issuer could face a single event or circumstance that would affect its ability to service/repay the debt. For example, a corporation could suffer an industrial accident.

1215

An investor holds a 20-year, semi-annual 8.00% coupon Treasury bond issued at par. Market interest rates are currently at 6.50%. The bond is noncallable. A coupon payment is due this week. Which of the following choices best represents the type of risk the investor faces?

A) Prepayment risk.

B) Credit risk.

C) Reinvestment risk.

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Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a holding return lower than that expected at purchase. Here, the investor will likely have to reinvest the coupon at the lower market interest rate, negatively impacting his holding period return.

Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments are most likely in a declining interest rate environment because it is cheaper to issue replacement debt. Here, the bond is a Treasury and is noncallable, so the investor can eliminate prepayment risk by holding the bond until maturity. Credit risk is the risk that the issuer will be unable to make coupon or principal payments as scheduled. Any change in the timing of the receipt of cash flows affects the bond’s holding period return. Credit risk is not a concern with Treasury securities.

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Which of the following statements about reinvestment risk is least accurate?

A) A bond's yield calculation assumes that coupon cash flows and principal can be reinvested at the computed yield to maturity.

B) A bond investor can eliminate reinvestment risk by holding a coupon bond until maturity.

C) An investor concerned about reinvestment risk is most concerned with a decrease in interest rates.

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The key word here is coupon bond. While an investor in a fixed-coupon bond can usually eliminate price risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupons exposes the investor to the risk that he will have to invest the coupons at a lower rate, thus negatively impacting his holding period return. An investor can greatly decrease reinvestment risk by holding a zero-coupon, noncallable bond that is not subject to other prepayments (or embedded options). Zero-coupon bonds deliver all cash flows in one lump sum at maturity.

The other statements about bond yield calculations and reinvestment risks are correct.

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Silhouette Enterprises must make a balloon loan payment of $1,000,000 in 3 years. The firm’s treasurer wants to purchase a bond that will provide funds for repayment and minimize reinvestment risk. Assume the company has the following three investment alternatives (all zero coupon bonds with face values of $1,000,000). Market rates are at 8.0%. All bonds are noncallable and are otherwise similar except as noted. Which bond best meets the treasurer’s requirements?

A) A 4-year, zero coupon bond priced to yield 8.5%.

B) A 2-year, zero-coupon bond priced to yield 9.0%.

C) A 3-year, zero coupon bond priced to yield 8.0%.

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Among the zero-coupon bonds, the one that best matches the loan’s maturity will minimize reinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. If he purchased the 4-year zero-coupon bond, he would have to sell the bond prior to maturity to pay off the loan and would face price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, the bond matures one year before the loan is due and would expose the firm to reinvestment risk.

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Kyle Barnes, CFA, is meeting his friend, Lita Rombach, about possible bond investments. Rombach is concerned about reinvestment risk. Which of the following statements about Rombach is CORRECT? Rombach:

A) will prefer a higher coupon bond to a lower coupon bond.

B) will prefer a noncallable bond to a callable bond.

C) need only be concerned about reinvestment risk on coupon payments.

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A noncallable bond reduces reinvestment risk by reducing the risk of repayment.

With her primary concern being reinvestment risk, Romach will prefer a lower coupon bond to a higher coupon bond. Reinvestment risk applies to all bond cash flows, not just the coupon payments.

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The reinvestment assumption is less important if the coupon and term to maturity are:

Coupon

Term to Maturity

A) lower shorter

B) lower longer

C) higher shorter

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This question is asking: when is the risk of a bond investor having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield?  Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. Reinvestment risk is important because the yield-to-maturity (YTM) calculation for a bond assumes that the investor can reinvest cash flows at exactly the coupon rate. (Note: YTM calculations are discussed in a later LOS.)

All else equal, the bond with the shorter term to maturity is less sensitive to changes in interest rates and prepayment rates. Here, this means that a shorter-term bond has lower reinvestment risk than a longer-term bond. 

All else equal, a lower coupon rate means that it is more likely that the investor can reinvest the coupon cash flow at near or equal to the yield-to-maturity. Here, this means that a lower coupon bond has less reinvestment risk.

In summary, reinvestment risk is least important with the combination of shorter maturity and lower coupon rate.

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Which of the following statements relating to reinvestment risk for bonds is CORRECT?

A) Long-term bonds should be purchased if the investor anticipates higher reinvestment rates.

B) Unless the reinvestment rate equals the yield to maturity, the holding period return will be less than the yield to maturity.

C) Zero coupon bonds have no reinvestment risk over their term.

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This statement is correct only if the investor holds the bond until maturity. Reinvestment risk means that a bond investor risks having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield. Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate bond reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. There are no payments over the life to reinvest.

The statement, "Long-term bonds should be purchased if the investor anticipates higher reinvestment rates," should read, "Short-term bonds...".If an investor expects interest rates to rise, he would want a bond with a shorter maturity so that he received his cash flows sooner and could reinvest at the higher rate. Also, there is less prepayment risk with shorter maturities.

The statement that begins, "Unless the reinvestment rate...," is partially true. However, the holding period return (covered in a later LOS) could be less or greater than the original yield to maturity (YTM). Over the investor's holding period, interest rates are likely to fluctuate both up and down; at some points the investor will reinvest at a higher rate than the original YTM and sometimes he will reinvest at a lower rate.

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Which of the following choices correctly places callable bonds, straight coupon bonds, mortgage-backed securities, and zero-coupon bonds in order from the type of security with the least reinvestment risk to the one with the most reinvestment risk?

A) zero-coupon bonds, straight coupon bonds, callable bonds, mortgage-backed securities.

B) zero-coupon bonds, mortgage-backed securities, straight coupon bonds, callable bonds.

C) callable bonds, straight coupon bonds, zero-coupon bonds, mortgage-backed securities.

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Of the three choices, zero-coupon bonds have the least reinvestment risk. An investor can nearly eliminate reinvestment risk by holding a noncallable zero-coupon bond until maturity because zero-coupon bonds deliver all cash flows in one lump sum at maturity.

Straight coupon bonds (no prepayment or other embedded options) have the next most reinvestment risk because of the periodic coupon payments. If interest rates decline, the bondholder will have to reinvest the coupons at a rate lower than that required to earn the original expected yield-to-maturity.

Callable bonds have more reinvestment risk because the right to prepay principal compounds reinvestment risk. A call option is one form of prepayment right that benefits the issuer, or borrower.

Mortgage backed and other asset backed securities have the most prepayment risk because in addition to cash flows from periodic interest payments (bond coupons, for example), these securities have periodic repayment of principal. The lower the interest rate, the higher chance that the loans underlying these assets will repay in full.

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Which of the following statements concerning reinvestment risk is most accurate?

A) Reinvestment risk is highest for zero-coupon bonds.

B) Reinvestment risk is increased if there are prepayment provisions on the bond.

C) Lower coupon bonds have more reinvestment risk.

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Reinvestment risk is increased if there are prepayment provisions that return a large amount of principal to the lender at a time when interest rates have declined. Note that the other statements are false. Reinvestment risk is lowest for zero coupon bonds – a corollary of this statement is that the lower the coupon, the less reinvestment risk there is for the bond.

1215

Consider three bonds that are similar in all features except those shown. The bond with the greatest reinvestment risk is:

A) 15% coupon, callable.

B) 15% coupon, non-callable.

C) 5% coupon, callable.

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Reinvestment risk is higher with high-coupon bonds because a larger proportion of their realized yield depends on reinvestment of the coupon interest payments. Callable bonds have more reinvestment risk than noncallable bonds, since their principal may be repaid earlier than the stated maturity date.