How do interest rate risk and reinvestment risk create an offsetting tradeoff for bond investors?

You're absolutely right that interest rate risk and reinvestment risk create a natural tug-of-war. Understanding this tradeoff is fundamental to fixed income and leads directly to the concept of immunization.

The Core Tradeoff

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Which Force Dominates? It Depends on Your Horizon.

• Short holding period (sell the bond before maturity): Interest rate risk dominates. You don't hold the bond long enough for reinvestment income to accumulate and offset a price decline.
• Long holding period (hold through maturity or beyond): Reinvestment risk dominates. You receive par at maturity regardless, so price changes don't matter — but the rate at which you reinvest coupons over many years has a huge impact.
• At the Macaulay Duration horizon: The two forces exactly offset. This is the key insight behind immunization.

Numerical Illustration — Prescott Industrial 8% Bond

Consider a 10-year, 8% annual coupon bond purchased at par ($1,000). Macaulay duration = 7.25 years.

If you plan to liquidate at exactly 7.25 years:

• Rate rise to 10%: Price at year 7.25 is lower, but you've been reinvesting coupons at 10% — the extra reinvestment income offsets the price loss.
• Rate fall to 6%: Price at year 7.25 is higher, but coupons were reinvested at only 6% — the lower reinvestment income offsets the price gain.

In both cases, your total wealth at the 7.25-year horizon is approximately the same.

Practical Implications:

1. Pension funds with known liabilities use this tradeoff to immunize — match portfolio duration to liability duration.
2. A barbell portfolio (short + long maturities) has higher reinvestment risk than a bullet portfolio (concentrated at one maturity) even if durations are equal.
3. Zero-coupon bonds eliminate this tradeoff entirely: no coupons means no reinvestment risk, and you hold to maturity so price risk is irrelevant.

Exam Tip: CFA Level I often tests whether you understand that for an investor whose holding period equals the bond's Macaulay duration, the two risks exactly offset.

Explore immunization strategies in our CFA Fixed Income course.