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Power of Compounding

Usually the payments are accumulated in an account at a lower interest rate before being reinvested. This means that the YTM almost always overstates the true return. If the interest earnings are spent rather than reinvested, the return will be even lower.

Reinvestment Risk

It is also important to recognize that the interest payments are normally trimmed by a tax bite, making it impossible to reinvest the full amount of each payment. The reason that YTM applies exactly to a zero coupon bond is that there is no interest to be reinvested. The entire return comes from the difference between the purchase price and the face value of the bond.

However in a zero coupon bond, that gain is treated as interest income and taxed annually according to the gain in accreted value. Since there are no interest payments to reinvest and therefore none to spend, achieving the quoted YTM is automatic when a zero coupon bond is held to maturity.

Should You Hold Bonds or Bond Funds When Interest Rates Rise?

Of course this ignores the annual income tax bite. YTM is almost always quoted in terms of bond-equivalent yield.

Discussion

This reflects the fact that bond interest payments are normally made twice a year at half the coupon rate. The compounding of the reinvested interest payments twice a year results in a slightly higher annualized return than would be the case for once-a-year reinvested interest payments at the full coupon rate.

YTM and Reinvestment Risk - Finance Train

Thus YTM expressed as bond-equivalent yield slightly understates the YTM when viewed as the annualized compound rate of return. When they decrease, bond coupons can only be reinvested at the new, lower rates.

Interest rate changes have opposite effects on a bond's price and reinvestment opportunities. While an increase in rates hurts a bond's price, it helps the bond's reinvestment rate. The goal of immunization is to offset these two changes to an investor's bond value, leaving its worth unchanged.


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A portfolio is immunized when its duration equals the investor's time horizon. At this point, any changes to interest rates will affect both price and reinvestment at the same rate, keeping the portfolio's rate of return the same. Maintaining an immunized portfolio means rebalancing the portfolio's average duration every time interest rates change, so that the average duration continues to equal the investor's time horizon.

CFA Tutorial: Fixed Income (Reinvestment Risk for Callable Bonds & Option Free Bonds)

A more direct form of immunization, "dedicating" a portfolio not only matches its duration to the investor's long-term time horizon, but also matches specific anticipated receipts of cash to the investor's specific anticipated liabilities along the way. To pay for college, for example, a parent might construct a bond portfolio so that interest and principal payments will be paid each year in September, when tuition is due. What Is Bond Immunization? Effects of Bond Immunization.

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