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Interest-rate, reinvestment and call risk

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Rising rates can lower a bond’s price. Falling rates can lower reinvestment income and make an allowed call more likely.

The ruleKeep three questions separate: did the market price change, did reinvested cash earn less, or did the payment date change? A zero has no interim coupon reinvestment.

Price, cash income and payment timing

Start with a plain fixed-rate bond. If market yields on comparable bonds rise, its price generally falls. If those yields fall, its price generally rises. Its fixed coupon does not change. Longer maturities usually bring more price sensitivity when other features are comparable.

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Holding to maturity avoids having to sell at the changed market price, but repayment still depends on the issuer paying as promised. Inflation and credit risk can remain.

Reinvestment risk concerns cash received: coupons, principal paid at maturity, or principal returned early. If that cash is reinvested at lower rates, the new investment may earn less. The coupon on a fixed-rate bond you still hold stays the same. Coupon rate and current yield do not include reinvested interest.

A callable bond gives the issuer an early redemption right under stated terms, such as a first call date and call price. Lower rates can make refinancing attractive, but a call is not automatic. If the issuer calls, it pays the stated call price and accrued interest as required, and future coupons on that bond stop.

A zero-coupon bond pays no interim coupons, so it has no coupons to reinvest before maturity. That does not mean borrowing is cost-free: interest is reflected in the difference between its issue price and promised payment. Its price may move more than that of a coupon bond of similar maturity. Reinvesting its maturity proceeds is a separate decision.

A mortgage-backed security (MBS) receives cash from a pool of mortgages. Principal may come back sooner or later than expected because borrowers can prepay. The structure of the security also affects which payments reach a holder.

Contraction risk means principal returns sooner than expected. Falling mortgage rates can encourage refinancing and faster prepayments, shortening the expected life of a pass-through holding. Returned cash may then be reinvested at lower rates.

Extension risk means principal returns later than expected. Rising rates can discourage refinancing and slow prepayments, extending the expected life of a pass-through holding. Cash stays invested longer, possibly at a lower rate than new investments offer. These are possible patterns, not a fixed outcome for every MBS or tranche.

Yield to call measures a callable bond on an assumption. It is the rate of return from principal and interest presuming the bond is redeemed on a specified call date, including any premium paid on the call; yield to maturity presumes instead that the bond stays outstanding until maturity. Neither yield is a promise. Quoting yield to call does not mean the issuer must call the bond; it describes what the investor would earn if it does.

Exam terms (7)
Interest-rate risk
Market rate changes can change a bond’s price; rising yields generally lower fixed-rate bond prices.
Reinvestment risk
Cash received may have to be reinvested at a lower rate to maintain the same type of investment.
Call risk
The issuer may redeem a callable bond early under its terms, ending future coupons.
Zero-coupon bond
A bond with no interim interest payments; its promised payment is due at maturity.
Refinancing
Replacing existing debt with new borrowing, often to reduce borrowing cost.
Contraction risk
Mortgage principal returns sooner than expected, often after faster prepayments as rates fall.
Extension risk
Mortgage principal returns later than expected, often after slower prepayments as rates rise.

Possible effects of falling rates

  1. Comparable rates fall

    New borrowing may cost less

  2. Fixed-rate prices can rise

    The existing coupon does not change

  3. Reinvested cash can earn less

    New income depends on the available rate

  4. An allowed call may occur

    Stated dates and prices still apply

  5. Called bond’s coupons stop

    Returned cash may earn less in a comparable new bond

Price gains do not guarantee higher cash income. A call depends on the terms and the issuer’s decision.

Try it: On paper, name the risk in each case. 1: A fixed-rate bond falls in price after yields rise. 2: A received coupon earns less when reinvested. 3: An allowed early call ends coupons. 4: Mortgage prepayments slow and principal returns later. Check: 1 interest-rate risk; 2 reinvestment risk; 3 call risk; 4 extension risk.

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Try a question, then read the explanation to review the rule.

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Worked example

An investor holds a $1,000 par fixed 7% corporate bond. It is callable now at $1,000 plus accrued interest. Comparable new bonds offer 4%, and the issuer chooses to call.

  1. Before the call, the annual coupon is $70 if paid as promised. A market rate change alone does not reduce it.
  2. Lower rates can raise the market price. A possible call may limit the gain, but its price and date are not a hard market-price ceiling in every situation.
  3. Here the call is an explicit fact: the issuer pays $1,000 plus accrued interest and the old bond’s future coupons stop.
  4. If the investor buys a comparable $1,000 par bond at par paying 4%, its annual coupon is $40. This is $30 less than the old bond’s $70. Different investments have different risks and terms.
  5. The call alone does not prove a profit or loss. The investor’s actual return also depends on the price paid, cash received and holding period.

Same rule, new context

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The closest contrast

Fixed coupon: unchanged while the bond is outstanding.

Reinvested cash: earns the new available rate.

A higher market price does not increase a fixed coupon. A lower reinvestment rate can reduce future income from received cash.

Summary

  • Rising comparable yields generally lower a fixed-rate bond’s price; the fixed coupon stays unchanged.
  • Lower rates can reduce income on reinvested coupons or principal, including cash received at maturity.
  • A call requires the bond’s stated terms and the issuer’s decision. After redemption, future coupons stop.
  • Zeros have no interim coupon reinvestment, but still have price risk.
  • MBS contraction means principal sooner than expected; extension means later than expected.

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