Interest-rate, reinvestment and call risk

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.

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

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.

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.

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