What Is Reinvestment Risk?
Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows received from an investment, such as coupon payments or interest, at a rate comparable to their current rate of return. This new rate is called the reinvestment rate.
Zero-coupon bonds (Z-bonds) are the only type of fixed-income security to have no inherent investment risk since they issue no coupon payments throughout their lives.
Key Takeaways
- Reinvestment risk is the chance that cash flows received from an investment will earn less when put to use in a new investment.
- Callable bonds are especially vulnerable to reinvestment risk because these bonds are typically redeemed when interest rates decline.
- Methods to mitigate reinvestment risk include the use of non-callable bonds, zero-coupon instruments, long-term securities, bond ladders, and actively managed bond funds.
Understanding Reinvestment Risk
Reinvestment risk is the likelihood that an investment's cash flows will earn less in a new security, creating an opportunity cost. It is the potential that the investor will be unable to reinvest cash flows at a rate comparable to their current rate of return.
For example, an investor buys a 10-year $100,000 Treasury note (T-note) with an interest rate of 6%. The investor expects to earn $6,000 per year from the security. However, at the end of the first year, interest rates fall to 4%.
If the investor buys another bond with the $6,000 received, they would receive only $240 annually rather than $360. Moreover, if interest rates subsequently increase and they sell the note before its maturity date, they stand to lose part of the principal.
In addition to fixed-income instruments such as bonds, reinvestment risk also affects other income-producing assets such as dividend-paying stocks.
Callable bonds are especially vulnerable to reinvestment risk. This is because callable bonds are typically redeemed when interest rates begin to fall. Upon redeeming the bonds, the investor will receive the face value, and the issuer has a new opportunity to borrow at a lower rate. If they are willing to reinvest, the investor will do so receiving a lower rate of interest.
Managing Reinvestment Risk
Investors may reduce reinvestment risk by investing in non-callable securities. Also, Z-bonds may be purchased since they do not make regular interest payments. Investing in longer-term securities is an option, too, since cash becomes available less frequently and does not need to be reinvested often.
A bond ladder, a portfolio of fixed-income securities with varying maturity dates, may help mitigate reinvestment risk as well. Bonds maturing when interest rates are low may be offset by bonds maturing when rates are high. The same type of strategy can be employed with certificates of deposits (CDs).
Investors can reduce reinvestment risk by holding bonds of different durations and by hedging their investments withinterest rate derivatives.
Having a fund manager can help reduce reinvestment risk; therefore, some investors consider allocating money into actively managed bond funds. However, because bond yields fluctuate with the market, reinvestment risk still exists.
Reinvested Coupon Payments
Instead of making coupon payments to the investor, some bonds automatically reinvest the coupon paid back into the bond, so it grows at a statedcompound interest rate. When a bond has a longer maturity period, the interest on interest significantly increases the total return and might be the only method of realizing an annualized holding period return equal to the coupon rate. Calculating reinvested interest depends on the reinvested interest rate.
Reinvested coupon payments may subsequently account for a good amount of a bond’s return to an investor. The exact amount depends on the interest rate earned by the reinvested payments and the time until the bond’s maturity date. The reinvested coupon payment may be calculated by figuring the compounded growth of reinvested payments, or by using a formula when the bond’s interest rate andyield-to-maturityrate are equal.
Example of Reinvestment Risk
Company A issues callable bonds with an 8% interest rate. Interest rates subsequently drop to 4%, presenting the company with an opportunity to borrow at a much lower rate.
As a result, the company calls the bonds, pays each investor their share of principal and a small call premium, and issues new callable bonds with a 4% interest rate. Investors may reinvest at the lower rate or seek other securities with higher interest rates.
FAQs
Key Takeaways
How can reinvestment risk be avoided? ›
Having some longer-maturity bonds or bond funds may help mitigate reinvestment risk in this situation. Adding duration with longer maturity holdings may help generate capital appreciation when rates fall. However, if rates have not yet peaked, this move would increase your interest rate risk.
What is reinvestment risk most closely associated with? ›
In practice, reinvestment risk is most common in the fixed income market for securities such as corporate bonds, where the issuer is obligated to pay interest to the investor per the lending agreement.
What is an example of reinvestment? ›
For example, suppose you own a stock that pays dividends. You can reinvest those dividends to buy more shares of the same stock. Reinvestment of Proceeds: This is when you use the money earned from selling an asset to buy a different asset.
What is the difference between reinvestment risk and refinancing risk? ›
Reinvestment risk refers to the risk of a lower return from the reinvestment of proceeds that the Group receives from prepayments and repayments of its loan portfolio. Refinancing risk is the risk of refinancing liabilities at a higher level of interest rate or credit spread.
How to manage reinvestment risk? ›
Methods to mitigate reinvestment risk include the use of non-callable bonds, zero-coupon instruments, long-term securities, bond ladders, and actively managed bond funds.
What is reinvestment risk in simple words? ›
What Does Reinvestment Risk Mean? Reinvestment risk refers to the probability that an investor will not be able to reinvest cash flows, such as coupon payments, at a rate equal to their current return. Zero-coupon bonds are the only fixed-income security that has no investment risk as no coupon payments are made.
What is the greatest level of reinvestment risk? ›
The CFAI states that "The bond with the highest coupon and the longest maturity will have the greatest reinvestment risk".
What increases reinvestment risk? ›
Reinvestment risk is often of greater concern when the yield curve is inverted. The yield curve plots the yield of securities against their time to maturity. This is usually upward sloping, reflecting the higher rate of return required in return for locking up funds for a longer period.
What is the difference between price risk and reinvestment risk? ›
Price risk is positively correlated to changes in interest rates, while reinvestment risk is inversely correlated.
Reinvestment is when income distributions received from an investment are plowed back into that investment instead of receiving cash. Reinvestment works by using dividends received to purchase more of that stock, or interest payments received to buy more of that bond.
What are the benefits of reinvestment? ›
One of the key benefits of dividend reinvestment is that your investment can grow faster than if you pocket your dividends and rely solely on capital gains to generate wealth. It's also inexpensive, easy, and flexible.
Is reinvestment risk long term or short term? ›
Shorter-term bonds are subject to greater reinvestment risk
All of this leads us to the central question: Why invest in a longer-term bond when you can get a similar yield with a shorter-term one? In two words: reinvestment risk.
What is a good reinvestment rate? ›
Deciding How Much to Reinvest
And, of course, there are operating expenses and overhead costs that keep it going. By reinvesting profits, however, you can drive growth and increase revenue. As noted, conventional wisdom suggests reinvesting 20% to 30%—some recommend up to even 50%—of profit back into your business.
Do treasury receipts have reinvestment risk? ›
Treasury Receipts long term, zero coupon bonds that pay interest only at maturity. There is no interest to reinvest during the life of the bond, therefore, STRIPS do not experience reinvestment risk. Reinvestment risk occurs when interest rates fall, forcing interest to be reinvested at lower rates of return.
Which investment has the lowest level of reinvestment risk? ›
Short-term investments have minimal reinvestment risk; and zero-coupon obligations have no reinvestment risk.
How reinvestment risk may be avoided if an investor purchases? ›
By investing in bonds with maturities of between 3 and 10 years, or in a bond mutual fund or ETF, with durations typically found in the US Aggregate Bond Index, you can avoid the risks posed by holding too much cash, and instead continue to earn the level of return you seek from your portfolio.
How can you minimize the risk from your investments? ›
Diversification: Diversification is a fundamental principle in risk management. Spreading your investments across different asset classes, industries, and geographic regions can significantly reduce the impact of a single investment's poor performance.
Do strips avoid reinvestment risk? ›
A strip bond has no reinvestment risk because there are no payments before maturity. On the maturity date, the investor is repaid an amount equal to the face value of the bond.
How can interest rate risk be prevented? ›
The interest rate risk can also be mitigated through various hedging strategies. These strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).
