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.
Reinvestment risk is most prevalent when it comes to bond investing, but any sort of investment that produces cash flow will expose the investor to this kind of risk.
How to Avoid Reinvestment Risk?
There are a few ways of mitigating the risk of reinvestment. Investing in non-callable securities is one method. This method prevents the borrower from calling off high-coupon investments when market rates are down. Note, nevertheless, that an investor still needs to find effective ways to reinvest those coupon payments in a low-rate environment.
Zero-coupon bonds will help investors in reducing their reinvestment risk as zero-coupon bonds do not pay coupons. Nevertheless, when the bond matures, an investor still has to determine ways via which he or she can reinvest in the proceeds.
An Example
The risk arises from the fact that interest or dividends received via an investment may not be feasible to be reinvested in a way wherein there could be gains in the same rate of return as the funds invested that generated it.
The dropping interest rates, for example, may prohibit bond coupon payments from receiving the same rate of return as the initial bond. A pension fund is also subject to reinvestment risk. Particularly with the short-term nature of cash investments, there is always a possibility of reinvesting future proceeds at lower interest rates.
Cons of Reinvestment Risk
- Nobody is entirely immune to this danger as it's practically everywhere, in every market.
- Investors with a knack on short-term bonds frequently fall prey to this type of risk.
