Comparing Interest Rate and Reinvestment Rate Risk

by Maestri

Note that interest rate risk relates to the value of the bonds in a portfolio, while reinvestment
rate risk relates to the income the portfolio produces. If you hold long-term bonds, you will face interest rate risk, that is, the value of your bonds will decline if interest rates rise, but you will not face much reinvestment rate risk, so your income will be stable. On the other hand, if you hold short-term bonds, you will not be exposed to much interest rate risk, so the value of your portfolio will be stable, but you will be exposed to reinvestment rate risk, and your income will fluctuate with changes in interest rates.

We see, then, that no fixed-rate bond can be considered totally riskless—even most Treasury bonds are exposed to both interest rate and reinvestment rate risk.13 One can minimize interest rate risk by holding short-term bonds, or one can minimize reinvestment rate risk by holding long-term bonds, but the actions that lower one type of risk increase the other. Bond portfolio managers try to balance these two risks, but some risk generally remains in any bond.

Taken From : Five-Minute MBA – Corporate Finance

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