Reinvestment Risk

What is the Definition of Reinvestment Risk?

Reinvestment risk is a form of financial risk where the proceeds from an investment cannot be reinvested at the same rate of return as the original investment.

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.

As part of the financing arrangement, the investor – i.e. the lender – expects to generate periodic interest payments that will subsequently be reinvested upon receipt.

The degree of reinvestment risk is contingent on the change in the market interest rate, which is an unpredictable external variable.

• Falling Interest Rates → Higher Reinvestment Risk
• Rising Interest Rates → Lower Reinvestment Risk

In the former scenario, the investor must reinvest the returned funds at a lower rate than the original debt issuance. But in the latter scenario, the investor can reinvest the returned funds at a higher rate than the interest rate on the original debt security.

In fact, the investor can force the issuer to repurchase the debt obligation if the underlying security is a puttable bond, i.e. a plain, vanilla bond with an embedded put option.

Therefore, the reinvestment risk can either benefit the lender (i.e. the investor) or the borrower (i.e. the issuer), which is a risk that must be understood by both parties.

How to Mitigate Reinvestment Risk?

The most frequently utilized strategies to mitigate the reinvestment risk in debt financing are as follows.

• Laddering → The laddering strategy refers to deliberately purchasing debt securities that mature at different times. In effect, the concentration of the risk is reduced as the investor is not exposed to an unfavorable fluctuation at once, since only a portion of the total investment comes up for reinvestment each year.
• Barbell Strategy → The barbell strategy involves investing into short-term and long-term bonds, intentionally leaving room between the maturities of the bonds. The intent is to obtain the flexibility to reinvest if rates change, while still reaping the monetary benefits from long-term bonds that offer higher yields, i.e. longer maturities coincide with higher returns because there is more uncertainty, for which investors must be compensated.
• Bullet Strategy → The bullet strategy describes an investment method where the purchased bonds all mature around the same time. The lump sum payment is most often appealing to those with a specified date by which the funds are needed but is only reasonable from a risk mitigation standpoint if the risk attributable to the securities is on the lower end.
• Non-Callable Bonds → For callable bonds, the issuer has the right to redeem the bond before maturity, forcing the issuer to return the principal and stop interest payments. But non-callable bonds, on the other hand, do not offer that option. Therefore, the interest payments on the bond across the term of the borrower are close to guaranteed.
• Portfolio Diversification → The concept of portfolio diversification is to simply not “put all your eggs in one basket”. By spreading the investments within a portfolio across different asset classes and sectors, the portfolio return is less sensitive to changes in the market interest rate.
• Zero-Coupon Bonds (“zeros”) → A zero-coupon bond, as implied by the name, does not issue periodic interest. Instead, the bonds are issued at a discount to face value, which is the core driver of returns. Since the bonds mature at face value (or “par value”), there is essentially no reinvestment risk because there were no periodic interest payments to reinvest.

What is an Example of Reinvestment Risk?

Suppose an investor purchased a 10-year semi-annual bond that pays a coupon based on an annual interest rate of 4.0%. Since the security is a semi-annual bond, interest is earned by the investor twice per year, so 2.0% every six months.

• Maturity = 10 Years
• Annual Interest Rate = 4.0%
• Semi-Annual Interest Rate = 2.0%

Over the course of the next five years, say the market interest rates fall to 2.0%, a reduction of 2.0% from the original issuance date.

Because of the reduction in the prevailing interest rate in the market, the investor can only reinvest the coupon payments at the current 2.0%, rather than the original 4.0%, which illustrates the concept of reinvestment risk.

Hypothetically, if the market interest rate remains at 2.0% until maturity, the principal is also subject to the reinvestment rate, not just the coupon payments.

What is the Difference Between Reinvestment Risk vs. Interest Rate Risk?

Reinvestment risk and interest rate risk are two closely tied types of financial risks associated with debt financing, particularly in the fixed-income market, where the securities pay periodic interest.

• Reinvestment Risk → Reinvestment risk, as mentioned earlier, is the risk that an investor will be unable to reinvest the interest payments from the borrower (and the principal at maturity) at a rate of return equal to the investment’s current yield.
• Interest Rate Risk → In contrast, the interest rate risk refers to the chance that the value of an investment – i.e. the pricing – will fluctuate based upon changes in the interest rate environment, i.e. the price of bonds and their yield have an inverse relationship. Hence, if interest rates rise after purchasing a bond, the price is likely to fall (and vice versa).

In conclusion, reinvestment risk pertains more to the impact on future cash flows (and the yield on reinvested funds), whereas interest rate risk references the effect that changing interest rates can have on the pricing of bonds.