Interest Rate Risk & Reinvestment Risk

These two risks are critically important for fixed-income investors and have an inverse relationship with each other. Understanding both is essential for bond portfolio management.

Interest Rate Risk

Interest rate risk (also called market risk for bonds) is the risk that rising interest rates will cause bond prices to fall.

The Fundamental Inverse Relationship

This is one of the most important relationships in fixed-income investing:

Why Does This Happen?

When new bonds are issued at higher rates, existing bonds with lower coupon rates become less attractive. Their prices must fall until their yield matches the new market rates.

Example:

• You own a bond paying 4% annual interest
• New bonds are issued paying 5%
• No one will pay full price for your 4% bond when they can buy a 5% bond
• Your bond's price must fall until its effective yield equals ~5%

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Factors Affecting Interest Rate Risk

1. Maturity

Longer maturity = Greater interest rate risk

Why? Longer-term bonds lock in a rate for more years, so rate changes have a bigger impact on their value.

2. Coupon Rate

Lower coupon = Greater interest rate risk

Why? With lower coupons, more of the bond's value comes from the final principal payment, which is more distant and therefore more sensitive to discounting.

3. Duration

Duration measures a bond's price sensitivity to interest rate changes.

Rule of Thumb: A bond with a duration of 7 years will change approximately 7% in price for each 1% change in interest rates.

Zero-Coupon Bond Duration: A zero-coupon bond's duration equals its maturity. A 20-year zero has a duration of 20 years—maximum interest rate risk.

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Reinvestment Risk

Reinvestment risk is the risk that interest payments or maturing principal cannot be reinvested at the same rate of return.

When Reinvestment Risk Is Highest

Examples

1. Falling rates: You receive a $50 coupon payment but can only reinvest at 3% instead of the original 5%

2. Callable bond called: Your 6% bond is called because rates dropped to 4%. You receive your principal back but can only reinvest at 4%

3. CD maturity: Your 5% CD matures and the best available renewal rate is 3%

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The Inverse Relationship Between These Risks

Interest rate risk and reinvestment risk are inversely related:

Key Insight: You cannot eliminate both risks simultaneously.

Zero-Coupon Bonds: A Special Case

Zero-coupon bonds eliminate reinvestment risk but have maximum interest rate risk.

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Immunization: Balancing Both Risks

Immunization is a strategy that balances interest rate risk and reinvestment risk by matching the portfolio's duration to the investor's time horizon.

Example: An investor needs funds in 8 years. By holding bonds with an 8-year duration, price changes and reinvestment rate changes approximately offset each other.

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In Practice: How Investment Advisers Apply This

Managing interest rate risk:

• Shorten duration when expecting rates to rise
• Extend duration when expecting rates to fall
• Ladder bond maturities to spread risk
• Consider floating-rate securities in rising rate environments

Managing reinvestment risk:

• Zero-coupon bonds eliminate reinvestment risk
• Avoid callable bonds when rates might fall
• Consider bond ladders for steady reinvestment

Client situations:

• Income-dependent clients: Focus on reinvestment risk
• Principal preservation: Focus on interest rate risk (shorter duration)
• Long-term goals: May accept interest rate risk for higher yields

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On the Exam

The Series 65 exam tests your understanding of:

1. Inverse relationship between bond prices and interest rates
2. Factors affecting interest rate risk (maturity, coupon, duration)
3. Duration as a measure of interest rate sensitivity
4. Reinvestment risk definition and when it's highest
5. Inverse relationship between interest rate risk and reinvestment risk
6. Zero-coupon bonds: Maximum interest rate risk, zero reinvestment risk

Expect 2-3 questions on these risks. Common formats include identifying which bond has more interest rate risk and understanding when reinvestment risk is highest.

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Key Takeaways

• Bond prices and interest rates move inversely
• Longer maturity = Greater interest rate risk
• Lower coupon = Greater interest rate risk
• Duration measures price sensitivity (7-year duration ≈ 7% change per 1% rate move)
• Zero-coupon bonds: Maximum interest rate risk, zero reinvestment risk
• Reinvestment risk is highest when rates are falling
• Interest rate risk and reinvestment risk are inversely related
• Immunization matches duration to investment horizon