Zero coupon bonds have no reinvestment risk

Contents

  1. Member Sign In
  2. reinvestment risk
  3. One of the Hazards of Investing in Bonds
  4. Reinvestment Risk Defined

The investors whose bonds are called back will receive their principal earlier and will have to find new avenues for investment. Apart from regular bonds, the amortizable fixed income securities face even more reinvestment risk.

In an amortizing security, the interest and a portion of principal is paid every month. If the interest rates in the market are falling, the principal may be prepaid prior to the scheduled payment dates, and the investor in such securities will have to reinvest at a lower interest rates.

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This is also cumbersome because the payments are received monthly and every month the investor will have to ensure the right investment to keep up the desired yield. In a rising interest rate environment, monthly proceeds may be advantageous because the investor can investment faster instead of waiting for 6 months. However, in a falling interest rate environment, this is a disadvantage to the investor. Due to the presence of reinvestment risk in these securities, many investors prefer zero-coupon bonds because in zero-coupon bonds there are no coupon payments and hence no reinvestment risk.

However, no coupon also means higher interest rate risk. Your email address will not be published. These risks can be hedged in a number of ways through built-in features or through external hedges.

Interest Rate Risk

Bond holders and traders often want to protect the value of their bond positions. There are many different financial instruments and derivatives that serve this purpose. Bond options and futures can be used to hedge against a price decline.

Swaps and interest-rate futures can shield the value of interest payments. Currency futures and options are used by traders to protect the value of foreign bonds from currency devaluation. All of these external hedges cost money to employ. Alternatively, some bonds are structured to provide built-in protections against certain risks. To reassure investors, issuers sometimes embed put options into bonds to hedge lenders against price risk.

reinvestment risk

The put options may have a delayed effective date, preventing redemptions for several years. The terms of the put option may cause bondholders to lose any interest accrued when they put the bonds. This reduces the total return on a bond investment. Zero coupon bonds automatically hedge this risk by not making periodic interest payments.

One of the Hazards of Investing in Bonds

Instead they are issued at a deep discount to face value. At maturity, the return of principal includes the imputed interest arising from the discount. There are no interest payments to reinvest, hence no reinvestment risk.

Some governments and large corporations hedge currency risk by issuing external bonds, which are bonds that are denominated and pay interest in the currency of another country. For example, eurodollar bonds are issued by members of the European Union, but they are denominated in U. Inflation can rob a bondholder of the value of her investment by making interest payments and principal repayments worth less in real terms. The U.

Reinvestment Risk Defined

Treasury issues Treasury Inflation Protected Securities to hedge against inflation risk. Twice a year, the Treasury adjusts the par value of these bonds to account for inflation. For example, if the Consumer Price Index rises 1 percent over a six-month period, the principal value of a TIPS bond is also increased by an amount equal to 1 percent multiplied by an index ratio assigned to each TIPS bond offering. He holds an M.