What Is Reinvestment Risk?

Posted by Robert Cobean on Jun 10, 2022

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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.

Long-Term Securities

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.

Bond Ladders

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.

Noncallable Bonds

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.

A bond’s yield, price and total return change daily and are based on changes in interest rates, market conditions, economic and political news, and the quality and maturity of its investments. In general, bond prices fall when interest rates rise, and vice versa. Unless otherwise noted, the actual amount and timing of distributions or interest payments are not guaranteed and may vary. Investing involves risks, including the loss of principal. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Examples shown are for illustrative purposes only. This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

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