What Is Reinvestment Risk?
There Are Several Ways to Lose Money Investing in Bonds. This Is One of Them.
Reinvestment risk is the risk that future cash flows – either coupons (the periodic interest payments on the bond) or the final return of principal – will need to be reinvested in lower-yielding securities.
An Example of Reinvestment Risk
For example, an investor constructs a portfolio of bond at a time when prevailing yields are running around 5 percent. Among his bond purchases, the investor buys a 5-year $100,000 treasury note, with the expectation of receiving $5,000 a year in annual income.
In the course of that five-year period, however, prevailing rates on this particular bond class fall to 2 percent. The good news is that the bondholder receives all scheduled 5 percent interest payments, as agreed, and at maturity receives full $100,000 of principal, also as agreed. So what's the problem?
The problem is that if now the investor buys another bond in the same class, he'll no longer receive 5 percent interest payments. The investor has to put the cash back to work at the lower rates. Now, that same $100,000 generates only $2,000 each year rather the $5,000 annual payments he received on the earlier note.
It's also worth noting that if the investor reinvests the interest income on the new note, she'll have to accept the lower rates that now prevail. If it should happen that interest rates afterward rise, the second 100,000 bond paying 2 percent falls in value. If the investor needs to cash out early -- to sell the bond before maturity -- in addition to the smaller payments per coupon, she'll also lose a portion of her principal. Remember the well-known formula: as interest rates rise, the value of a bond falls until its current yield is equals the yield of a new bond paying higher interest.
Another Related Risk
Reinvestment risk also occurs with callable bonds. “Callable” means that the issuer can pay off the bond before maturity. One of the primary reasons bonds are called is because interest rates have fallen since the bond's issuance and the corporation or the government can now issue new bonds with lower rates, thus saving the difference between the older higher rate and the new lower rate. It makes sense to do this and it's a part of the contract the investor agrees to when buying a callable bond, but, unfortunately, this also means that.
once again, the investor will have to put the cash back to work at the lower prevailing rate.
Avoiding Reinvestment Risk
Investors can try to fight reinvestment risk by investing in longer-term securities, since this decreases the frequency at which cash becomes available and needs to be reinvested. Unfortunately, this also exposes the portfolio to even greater interest rate risk.
What investors may sometimes do—and did so increasingly in the low-interest rate environment that followed the collapse of financial markets in late 2007—is to try to make up the lost interest income by investing in high-yield bonds (otherwise known as junk bonds). This is an understandable, but dubious, strategy because it's also well-known that junk bonds fail at particularly high rates when the economy isn't doing well, which generally coincides with a low-interest rate environment.
A Better Strategy
A better way of at least partially mitigating reinvestment risk is to create a “bond ladder,” a portfolio holding bonds with widely varied maturity dates. Because the market is essentially cyclical, high-interest rates fall too low and then rise again. Chances are only some of your bonds will mature in a low-interest rate environment and these can usually be offset by other bonds that mature when interest rates are high.
Investing in actively managed bond funds may reduce the impact of reinvestment risk, because the fund manager can take similar steps to mitigate risk. Over time, however, the yields on bond funds do tend to rise and fall with the market, so actively managed bond funds provide only limited protection against reinvestment risk.
Another possible strategy is to reinvest in investments not directly affected by falling interest rates. One of the truisms of investments generally is to make them as uncorrelated as possible. This strategy, if successfully executed achieves that. But it also involves a degree of sophistication and investment experience that not many retail investors possess.