101 Concepts for the Level I Exam

For a fixed rate bond purchased at par, there are three sources of return:

- Receipt of the promised coupon and principal payments.
- Reinvestment of coupon payments.
- Potential capital gains (or losses) on the sale of the bond prior to maturity.

If a bond is purchased at a discount or premium, the rate of return also includes the effect of the price being “pulled to par” as we approach maturity. Total return of a bond = reinvested coupon interest payments + sale/redemption of principal at maturity.

Changes in interest rate affect the realized rate of return for any bond investor in two ways:

**Market price risk**: Bond prices are inversely proportional to interest rate movements. Bond price decreases when the interest rate goes up.**Coupon reinvestment risk**: Value of coupon payments is directly proportional to interest rate movements. The value of reinvested coupons increases when the interest rate goes up.

Market price risk dominates coupon reinvestment risk when the investor has a short-term horizon. Coupon reinvestment risk dominates market price risk when the investor has a long-term horizon: for instance, a buy-and-hold investor.