Reinvestment risk zero coupon bond




One of the Hazards of Investing in Bonds

C is correct because duration assumes that yields change by the same amount across all maturities.

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A bond is selling for It is estimated that the price will fall to Based on these estimates, the duration of the bond is closest :. The dollar duration of the bond is closest to :. Compared with an otherwise identical amortizing security, a zero-coupon bond will most likely have :. Less reinvestment risk : An amortizing security is exposed to reinvestment risk since it receives periodic payments of both interest and principal that must be reinvested ; while a zero-coupon bond has no reinvestment risk since no cash flows are received that must be reinvested before maturity.

Interest rate risk and reinvestment risk in bond investment

More interest rate risk : Because zero-coupon bonds do not have periodic cash flows, they have higher interest rate risk for a given maturity and a given change in market yields. Two amortizing bonds have the same maturity date and same yield to maturity. The reinvestment risk for an investor holding the bonds to maturity is greatest for the bond that is :. Reinvestment risk refers to the risk that interest rates will decline causing the future income expected from reinvesting coupon payments to decline. The higher the coupon being paid, the greater the reinvestment risk.

Because the two amortizing bonds have the same maturity date and the same yield to maturity, the bond selling at a premium must have a higher coupon rate and a higher amount requiring reinvestment and thus higher reinvestment risk. An investor fears that economic conditions will worsen and the market prices of her portfolio of investment-grade corporate bonds will decrease more than her portfolio of government bonds.

A is not correct. B is not correct.

Default risk is the risk that the issuer not making timely interest and principal payments as promised. C is the correct answer. Credit spread risk is the risk that the yield required in the market for a given rating can increase even while the yield on the Treasury security of similar maturity remains unchanged. Thus the investor is concerned about credit spread risk.

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How reinvestment risk in debt mutual funds can hit your returns

For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain investment grade, the greatest risk is most likely :. Credit spread risk is correct since the bond is expected to see a widening of spreads as a result of deteriorating fundamentals and a potential downgrade but still remaining investment grade. What risk does the bid-ask spread most closely measure :. A is correct. Liquidity risk is the risk that the investor will have to sell a bond below its indicated value.

The size of the spread between the bid price and the ask price is the primary measure of liquidity of the issue. If trading activity in a particular security declines, the bid-ask spread will widen, and the issue is considered less liquid. All else equal , an increase in expected yield volatility is most likely to cause the price of a :. An increase in expected yield volatility increases the values of both put options and call options.

Note here the call option is retained by the issuer. Note here the put option is owned by the bond holder. Similarly, if you are looking to earn a regular income from the coupon interest received on the bonds, and if the bonds are reinvested at lower rates, then the income you earn will come down. Buying zero-coupon bonds or deep discount bonds, where you buy the bond at a discount to its face value and receive the face value on maturity, is one way to avoid reinvestment risk as here there is no periodic interest payment to invest.

Another way is to tie into a higher yield by investing in long-term bonds when you expect lower interest rates in the future. Reinvestment risk can also be managed by choosing the cumulative option in bonds and deposits where the periodic interest income is reinvested in the same bond or deposit and earns the same rate of interest as the original investment. On maturity of the investment, the principal and the accumulated interest is paid to the investor.

If you are looking to earn regular income from your bond portfolio, then a laddered bond portfolio can reduce the impact of reinvestment risk.

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To implement this strategy, you invest the same amount of money in bonds that are maturing at different intervals. In effect, you have tied in to the interest rate prevalent in the market now and know with certainty the income you will receive for the next few years depending upon the number of steps years you have created.

Each year, one set of bonds will mature and you have the money you need to use for your needs or to invest in a new step at the top of the ladder. If the interest rate has gone up, then you invest at the higher rate. If the interest rate is lower, you invest at this lower rate, but since this will be only a small portion of your investment, the impact on the total return will be lower. For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond. Pension funds are also subject to reinvestment risk.

What Is Reinvestment Risk?

Especially with the short-term nature of cash investments, there is always the risk that future proceeds will have to be reinvested at a lower interest rate. Reinvestment risk affects the yield-to-maturity of a bond, which is calculated on the premise that all future coupon payments will be reinvested at the interest rate in effect when the bond was first purchased. Maturity of the bond - The longer the maturity of the bond, the higher the likelihood that interest rates will be lower than they were at the time of the bond purchase.

Interest rate on the bond - The higher the interest rate, the bigger the coupon payments that have to be reinvested, and, consequently, the reinvestment risk. Zero coupon bonds are the only fixed-income instruments to have no reinvestment risk, since they have no interim coupon payments.

Boundless Finance. Bond Valuation.

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