Key Takeaways
- 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.
Definition and Example of 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.
For example, if you buy a bond with yield rates that are falling over time, you risk a lower yield rate if you want to reinvest those funds in the same bond after it matures.
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 would receive all scheduled 5% interest payments and the full $100,000 principal at maturity. However, the problem is that if the investor were to buy another bond in the same class, they'd no longer receive 5% interest payments; they have to put the cash back to work at the lower prevailing rates. That same $100,000 would generate 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 were to rise, the second $100,000 bond paying 2% would fall in value.
Note
If the investor needs to cash out early, in addition to the smaller coupon payments, they'd also lose a portion of their principal. As interest rates rise, the value of a bond falls until its current yield equals that of a new bond paying higher interest.
Reinvestment risk also occurs withcallablebonds, which allow the issuer to pay off the bond before maturity. One of the primary reasons bonds get called is because interest rates have fallen since their 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, it also means that the investor will have to put the cash back to work at the lower prevailing rate if they choose to keep the proceeds in bonds.
What Reinvestment Risk Means for Individual Investors
What investors may sometimes do—and did increasingly in the low-interest-rate environment that followed the collapse of financial markets in late 2008—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 thatjunk bonds fail at particularly high rateswhen the economy isn't doing well, which generally coincides with a low-interest-rate environment.
Note
Investors can try to fight reinvestment risk by investing inlonger-termsecurities, which decreases the frequency at which cash becomes available and needs to be reinvested. Unfortunately, this strategy also exposes the portfolio to even greaterinterest rate risk.
Other Strategies for Mitigating Reinvestment Risk
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 inactively managedbondfundsmay 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 instruments that are not directly affected by falling interest rates. One goal of investing generally is to make holdings as uncorrelated as possible. To do so effectively involves a degree of sophistication and investment experience that not many retail investors possess, however.
