Reinvestment risk is the risk that future cash flows—either coupons or the final return of principal—will need to be reinvested in lower-yielding securities.
Learn more about the role reinvestment risks play in investing and how to limit your exposure to them.
What Is Reinvestment Risk?
Reinvestment risk is the chance that an investor will have to reinvest money from an investment at a rate lower than its current rate. This risk is most commonly found with bond investing, though it can apply to any cash-generating investment.
How Reinvestment Risk Works
Suppose that an investor constructs a portfolio of bonds when prevailing yields are running at around 5%, and among their bond purchases, the investor buys a five-year $100,000 treasury note, expecting $5,000 per year in annual income. Let's assume that prevailing rates on this particular bond class fall to 2% in those five years.
The good news is that the bondholder receives all scheduled 5% interest payments and the full $100,000 principal at maturity. However, the problem is that if the investor buys another bond in the same class, they'll no longer receive 5% interest payments; the investor has to put the cash back to work at the lower prevailing rates. That same $100,000 generates only $2,000 each year rather than the $5,000 annual payments they received on the earlier note.
If the investor reinvests the new note's interest income, they'll also have to accept the lower rates that now prevail. If interest rates then rise, the second $100,000 bond paying 2% falls in value.
If the investor needs to cash out early, in addition to the smaller coupon payments, they'll also lose a portion of their principal. As interest rates rise, the value of a bond falls until its current yield equals the yield of a new bond paying higher interest.
Reinvestment risk also occurs with callable bonds, which allows the issuer to 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 higher rate and the new lower rate.
It makes sense for the issuer to do this. It's a part of the contract the investor agrees to when buying a callable bond. Still, unfortunately, this also means that 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.
Another way of at least partially mitigating reinvestment risk is to create a bond ladder, which is a portfolio holding bonds with widely varying maturity dates. Because the market is essentially cyclical, high interest rates fall too low and then rise again. Chances are that 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 goal 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.
The information on this site is provided for discussion purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
- Reinvestment risk is the chance that an investor will have to reinvest money from an investment at a rate lower than its current rate.
- Reinvestment risk is most commonly found with bonds.
- Noncallable bonds help stop reinvestment risk.