Let’s say you’re an investor with a portfolio of bonds, and one of those bonds is nearing its maturity date. Thanks to the relatively high interest rate attached to that bond when you first invested in it, you’re looking forward to reinvesting in the same bond at the same class.
Only to find that the interest rate dropped significantly.
Welcome to the world of reinvestment risk.
Describing Investment Risk
As illustrated by the above hypothetical situation, reinvestment risk is the potential that a cash flow you receive from a particular investment will earn less when placed in a new investment. Reinvestment risk is a form of financial risk, in which you, the investor, might have to settle for a lower rate of return.
Reinvestment risk typically occurs with fixed-income securities, such as amortizable fixed-income securities. Callable bonds are also highly susceptible to reinvestment risk. If interest rates fall, the issuer of callable bonds might decide to “call back” the bonds and issue new ones at lower interest rates. While this means you could receive your principal before the original maturity date, it also means that reinvestment in the new lower-interest-rate bonds could mean a reduction in your returns.
Let’s look at the following hypothetical situation.
You buy a 10-year $100,000 Treasury note at a 3% interest rate. If that interest rate should drop to 2%, you would still receive the scheduled $3,000 a year in interest payments and the $100,000 principal upon the note’s maturity. But the 2% interest rate means that if you decide to reinvest that principal in another Treasury note, you’d lose $1,000 a month in proceeds. Another issue is that if the interest rate returns to 3%, you would still be receiving the 2% interest rate.
Can You Manage It?
First, as we keep mentioning, there is no such thing as a risk-free investment. Furthermore, it’s potentially impossible to really get rid of reinvestment risk. But there are ways to potentially help manage it.
Longer-term securities could lower the frequency during which cash becomes available and would need to be reinvested. The potential downside of this strategy is possible exposure to greater interest rate risk, which is a bond’s sensitivity and reaction to interest rate changes.
A bond ladder is a portfolio that holds bonds with varying maturity dates. As is the case with Modern Portfolio Theory, some bonds maturing in a lower interest rate environment might be offset by others that mature when interest rates are higher.
Through a noncallable bond, the issuer is expected to pay the originally agreed-upon interest rate until maturity. There is no chance that the issuer will call in the bond early. Treasury securities are typical examples of noncallable bonds.
Broaden Your Investment Pool
Nothing says you must reinvest your bond proceeds into the same or similar bond. Putting those monies into assets that aren’t directly impacted by falling interest rates could help manage reinvestment risk. If you are seeking to expand your investment pool, a financial professional might be able to help.