Securities reinvestment

The source of dollar return called reinvestment income represents the interest earned from reinvesting the bond s interim cash flows (interest and/or principal payments) until the bond is removed from the investor s portfolio. With the exception of zero-coupon bonds, fixed income securities deliver coupon payments that can be reinvested. Moreover, amortizing securities (e.g., mortgage-backed and asset-backed securities) make periodic principal repayments which can also be invested. 

Although it is commonly quoted by market participants, the cash flow yield suffers from limitations similar to the yield to maturity. These shortcomings include (1) the projected cash flows assume that the prepayment speed will be realized (2) the projected cash flows are assumed to be reinvested at the cash flow yield and (3) the mortgage-backed or asset-backed security is assumed to be held until the final payoff of all the loans in the pool based on some prepayment assumption. If the cash flows are reinvested at rate lower than the cash flow yield (i.e., reinvestment risk) or if actual prepayments differ from those projected, then the cash flow yield will not be realized. Mortgage-backed and asset-backed securities are particularly sensitive to reinvestment risk since payments are usually monthly and include principal repayments as well as interest. 

In the case of a bonds borrowed/collateral pledged trade the institution lending the bonds does not want or need to receive cash against them, as it is already cash rich and would only have to reinvest any further cash generated. As such this transaction only occurs with special collateral. The dealer borrows the special bonds and pledges securities of similar quality and value (general collateral). The dealer builds in a fee payable to the lending institution as an incentive to do the trade. 

After the termination of the Ramp-Up Period, the Reinvestment Period will start. This period has traditionally lasted around five years, but nowadays, we are seeing longer Reinvestment Periods. In this deal, the Reinvestment Period will last seven years from the Final Closing Date. During the Reinvestment Period, any proceeds received by the issuer upon redemption of any Collateral Debt Securities will be reinvested in further Collateral Debt Securities subject to compliance with any rating agency requirements. 

No investment may be made in Collateral Debt Securities or Eligible Investments (as described below) after the termination of the Reinvestment Period or as a result of the suspension of such Reinvestment Period due to a failure of the overcollateralisation ratio test. 

If the principal of the short-term security described above is continuously reinvested at this short rate, the cumulative amount obtained at time t is equal to the original investment multiplied by expression (3.12). 

These bonds have the longest duration of all indexed securities and no reinvestment risk. 

Annuity indexation. Indexed-annuity bonds have been issued in Australia, although not by the central government. They pay a fixed annuity payment plus a varying element that compensates for inflation. These bonds have the shortest duration and highest reinvestment risk of all index-linked debt securities. 

Between the short- and long-term horizon dates is one at which the net effect of the change in reinvestment rate on the bond s future value is close to zero. At this date, the bond behaves like a single-cash-flow or zero-coupon security, and its future value can be predicted with greater certainty, no matter what the yield curve does after its purchase. Defining this date as Sh interest periods after the purchase date and Ph as the value of the bond at that point, it can be shown that the bond s rate of return up to this horizon date is the value for rntn that solves equation (16.6). 

Zero-coupon indexation. Zero-coupon indexed bonds have been issued in Sweden. As their name implies, they pay no coupons the entire inflation adjustment occurs at maturity, applied to their redemption value. These bonds have the longest duration of all indexed securities and no reinvestment risk. 

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