Finance Assignment Help With Reinvestment Risk

Reinvestment Risk

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Reinvestment risk occurs when:

  • The yields of reinvestment opportunities are lower than the original yield.
  • The computation of the yield depends on the reinvestment rate of the coupon payments.

Prepayable amortizing securities expose investors to greater reinvestment risks because the proceeds of principal repayment, coupon, and pre payments might only be able to be reinvested at a lower yield, particularly during a declining interest rate environment.

The targeted yield may not be achieved since the yield-to-maturity calculation assumes that the reinvestment yield is the same as when the bonds were purchased.

Credit risk

There are three types of credit risk:

  • Default risk

This is when an issuer fails to meet the obligation of interest and principal payments. A single delay in an interest payment on the coupon payment date is considered a default.

An investor does not necessarily lose the whole amount of the principal and accrued interest when a default occurs. The percentage amount recoverable in a case of a default is called the recovery rate. Based on the historical data on default rates and recovery rates of outstanding bonds in the market, credit rating agencies evaluate and classify the creditworthiness of the issuers or issues.

  • Credit spread risk

This is when the yield spread of a particular issue or sector widens against the risk-free benchmark causing the price of the bond to decline (usually due to macroeconomic factors). Similar to floating-rate securities, fixed-rate bonds are priced by two components: (1) the yield of a risk-free bond with a similar maturity and (2) a premium above the yield of the similar risk-free bond.

This premium is similar to a quoted margin, i.e. the price of the credit risk. It is the compensation required by the investor for taking on an additional credit risk vis-à-vis the risk-free bond. This premium can increase or decrease depending upon the market’s perception of the credit risk.

  • Downgrade risk

This is when a rating agency (e.g. Standard & Poor's, Moody's or Fitch) decides the individual creditworthiness of a bond has deteriorated. The credit spread will widen due to the downgrade which will lead the bond price to decline. The rating agencies’ opinions on individual issues are very influential in the bond market.

Credit ratings

A credit rating is a measure of potential default risk by an issuer related to a particular bond issue. An investor looks into a credit rating symbol to give him or her an idea of the ability of an issuer to meet the payment obligation of the principal and interests as stipulated in the indenture.

A credit rating symbol is a summary of a more complex analysis on a company.

Credit ratings make the jobs of an analyst easier because he or she can focus on bonds of interest.

Credit ratings also help the market determines the prices the bonds according to market perception of the risks.

There are three main credit rating agencies in the U.S.: Standard and Poor's, Moody's Investors Service, Inc. and Fitch.

Liquidity risk

This is the risk which is faced by investors when they are forced to sell a bond at a price below its true value perhaps due to a temporary imbalance of supply and demand for the individual bond. The market liquidity of an issue is reflected by the size of the bid-ask spread quoted by dealers. The wider the bid-ask spread, the less liquid is the issue in the market. Market liquidity should not be confused with the financial liquidity of the issuer as a going concern. Liquidity risk is important to investors who mark their portfolios to the market, regardless of whether they intend to hold a security to maturity or sell it the next day. Mark-to-market is an exercise to revalue the portfolio based on the current market prices of the individual securities that make up the portfolio.

Exchange rate risk

This is also called currency risk; it is the risk that the currency of the investment moves adversely against the home currency causing the local currency value of coupon payments and the principal repayment to decrease.

Inflation risk

This is the risk that the purchasing power of income from bonds is reduced due to the erosion in their value by inflation. The identical amount of coupon paid out on different coupon payment dates will decrease in value according to the prevailing inflation rate. It exists because inflationary pressure is almost always present in different economies. Investing in inflation protection bonds can mitigate this type of risk.

Volatility risk

Changes in the expected volatility of yield change the value of embedded options in a bond.

Option theory says that the value of an option is directly related to the level of volatility. Therefore when the volatility of the expected yield rises, the value of the embedded option will rise.

Event risk

This risk occurs very infrequently but with a serious impact on the issuer's ability to honor its debt obligation. There are four main factors:

  • Natural catastrophe risk, including the risk of an earthquake, hurricane, floods or industrial accidents. This type of event will lead to a downgrade but is normally confined to individual issuers.
  • Corporate restructuring risk, such as occurred with RJR Nabisco's bonds during the leverage buyout (LBO) wave in the 1980s. Investors demanded an additional yield of 250 basis points after the LBO of RJR Nabisco was announced. The announcement subsequently affected the whole sector as investors temporarily withdrew from the market.
  • Regulatory change risk. An example was the passing of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1994. The legislation drastically limited the exposure of the Savings and Loans industry to non-investment grade bonds. As a result the ensuing divestments from such bonds created a collapse in the market. Prices declined by 20% to 25% without any fundamental change in their creditworthiness.

Sovereign risk

This is the risk that an investor assumes when investing in securities issued by foreign governments. Changes in political circumstances or in economic policies might affect the capacity and ability of the issuer to pay the coupons or principal. Sovereign risk can either be caused by inability or unwillingness to pay. In most cases foreign governments default on their obligations due to unfavorable economic conditions that adversely affect their ability to pay rather than due to their one-sided repudiation of the debts.

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