Does anyone understand the “reinvest them at a lower return than the YTM at purchase”? This confuses me. If you could clear this up – id appreciate it!
If the yield to maturity on a bond decreases after purchase but before the first coupon date and the bond is held to maturity, reinvestment risk is:
less than price risk and the realized yield will be higher than the YTM at purchase.
less than price risk and the realized yield will be lower than the YTM at purchase.
greater than price risk and the realized yield will be lower than the YTM at purchase.
If the bond is held to maturity, the investor will receive all coupons and principal and reinvest them at a lower return than the YTM at purchase, resulting in a lower realized yield.
(Study Session 15, Module 46.1, LOS 46.a)
If YTM drops before a coupon is paid, that means you will reinvest your coupon (which is fixed $) at a lower interest rate than at inception (when you first bought the bond).
Therefore, you’ll get a lower yield from reinvesting your coupon ==> reinvestment risk increases.
Since the bond is held to maturity, this means that there is less/no price risk (i.e. making a loss if the bond is sold before maturity, where sale price may be lower than purchase price if YTM has increased).
Both price risk and investment risks offset each other partially. The shorter the investment horizon, the smaller the coupon reinvestment risk, but the bigger the market price risk, and vice versa.
Understood on both risk risk and investment offset each other due to market and reinvestment from the investment horizon.
Follow up question is – this is all under the assumption that we would take our fixed coupon payment and reinvestment that $$ paid to us (in the form of a coupon) and into this same theoretical bond, correct?
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