Finance

Reinvestment Risk

Reinvestment Risk

There are a variety of risks involved with bond investing and reinvestment risk is among the major forms of financial risk. This phrase indicates the risk of somehow canceling or stopping a particular investment, and of seeking a new place to invest their capital. This however includes the possibility that no appealing investment could be accessible.

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What is Reinvestment Risk?

Reinvestment risk refers to a scenario that an investor will be unable to reinvest cash flows received like coupon payments, at a rate comparable to their current rate of return. It is the risk that future cash flows—either coupons or the final return of principal—will need to be reinvested in lower-yielding securities. Bonds such as zero-coupon issue no coupon payments hence are the only fixed-income security to have no investment risk. The use of non-callable bonds, zero-coupon instruments, long-term securities, bond ladders, and actively managed bond funds, are a few methods that can be used to mitigate reinvestment risk.

Example:

Reinvestment risk is the likelihood that an investment’s cash flows will earn less when reinvested in new security. For example, an investor buys an Rs.100,000 Treasury note with an interest rate of 6% for a period of 10 years. The investor expects to earn Rs. 6,000 per year from the security.

However, at the end of the term, interest rates fall to 4%. If the investor buys another Rs.100,000 Treasury note for the next 10 years, they will earn Rs.4,000 annually rather than the previous Rs.6,000. In another case, if interest rates increase subsequently and they sell the note before its maturity date, they will end up losing a part of the principal.

Callable bonds are extremely vulnerable to reinvestment risk because they are typically redeemed when interest rates begin to fall. When the bond is redeemed, the investor will receive the face value and the issuer will have a new opportunity to borrow at a lower rate. If they are willing to reinvest, the investor will do so while receiving a lower rate of interest as compared to the previous one.

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Avoiding Reinvestment Risk:

To fight against reinvestment risk investors can start investing in longer-term securities since this decreases the frequency at which cash becomes available and needs to be reinvested. But at the same time, this also exposes the portfolio to even greater risk which is interest rate risk.

What investors can do sometimes and have done so increasingly in the low-interest-rate environment that followed the collapse of financial markets during the financial crisis of 2007-08 is to try to make up the lost interest income by investing in high-yield bonds (also known as junk bonds). This is an understandable but risky strategy because we know that junk bonds fail at particularly high rates when the economy isn’t doing well, which generally coincides with a low-interest-rate environment.

Another way that helps to partially mitigating reinvestment risk is by creating a bond ladder, which is a portfolio that holds bonds with widely varying maturity dates. This is because the market is essentially cyclical, high interest rates fall too low and then rise again. Chances are that only a few 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 in actively managed bond funds also helps to reduce the impact of reinvestment risk because the fund manager can take similar steps to mitigate risk. However, over the period of time the yields on bond funds do tend to rise and fall with the market, hence actively managed bond funds provide limited protection against reinvestment risk.

Another possible strategy is to reinvest in investments that are not directly affected by falling interest rates. Our goal of investments will be to make them as uncorrelated as possible. This strategy, if successfully executed, helps in achieving that. Not to forget, it also involves a high degree of sophistication and investment experience that not many retail investors might possess.

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Conclusion:

An investor’s calculation of bond price as the present value of cash flows is based on the assumption that all future cash flows are reinvested at Yield to Maturity or the expected rate of return. Market rates are highly impacted with even the slightest change, which in turn impacts our calculations and finances. The only way to reduce risk to some extent is to construct a well thought of and researched bond portfolio. However complete elimination cannot be avoided.

 

Author: Mahek Medh

About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.

 

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