17/12/2019 Reinvestment Risk Defined

TRADING SKILLS & ESSENTIALS RISK MANAGEMENT

Reinvestment Risk
By JASON FERNANDO | Updated Sep 12, 2019

What Is Reinvestment Risk?

Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash
flows (e.g., coupon payments) at a rate comparable to their current rate of return. Zero-
coupon bonds are the only fixed-income security to have no investment risk since they issue
no coupon payments.

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KEY TAKEAWAYS
Reinvestment risk is the likelihood that an investment's cash flows will earn less in a
new security.
Callable bonds are especially vulnerable to reinvestment risk because the bonds are
typically redeemed when interest rates decline.
Methods to mitigate reinvestment risk include the use of non-callable bonds, zero-
coupon instruments, long-term securities, bond ladders, and actively managed
bond funds.

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Reinvestment Risk

Understanding Reinvestment Risk

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

However, at the end of the term, interest rates are 4%. If the investor buys another 10-year
$100,000 Treasury note, they will earn $4,000 annually rather than $6,000. Also, if interest
rates subsequently increase and they sell the note before its maturity date, they lose part of
the principal.

Important: In addition to fixed-income instruments such as bonds, reinvestment

risk also affects other income-producing assets such as dividend-paying stocks.

Callable bonds are especially vulnerable to reinvestment risk. This is because callable bonds
are typically redeemed when interest rates begin to fall. Upon redeeming the bonds, the
investor will receive the face value, and the issuer has a new opportunity to borrow at a
lower rate. If they are willing to reinvest, the investor will do so receiving a lower rate of
interest.

Real World Example of Reinvestment Risk

For example, Company A issues callable bonds with an 8% interest rate. Interest rates
subsequently drop to 4%, presenting the company with an opportunity to borrow at a much
lower rate. As a result, the company calls the bonds, pays each investor their share of

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principal and a small call premium, and issues new callable bonds with a 4% interest rate.
Investors may reinvest at the lower rate or seek other securities with higher interest rates.

Investors may reduce reinvestment risk by investing in non-callable securities. Also, zero-
coupon bonds may be purchased since they do not make regular interest payments.
Investing in longer-term securities is also an option since cash becomes available less
frequently and does not need to be reinvested often.

A bond ladder, a portfolio of fixed-income securities with varying maturity dates, may help
mitigate reinvestment risk. Bonds maturing when interest rates are low may be offset by
bonds maturing when rates are high.

Having a fund manager can help reduce reinvestment risk; therefore, some investors
consider allocating money into actively managed bond funds. However, because bond yields
fluctuate with the market, reinvestment risk still exists.

Related Terms
Reinvestment
Reinvestment is using dividends, interest, and any other form of distribution earned in an investment
to purchase additional shares or units. more

Laddering
Laddering is a scheme to manipulate initial public offering (IPO) prices. It's also an investing strategy
to buy multiple products of different maturities. more

What Investors Need to Know Before Investing in Callable Bonds

A callable bond is a bond that can be redeemed by the issuer prior to its maturity. A callable bond
pays investors a higher rate than standard bonds. more

Bond
A bond is a fixed income investment in which an investor loans money to an entity (corporate or
governmental) that borrows the funds for a defined period of time at a fixed interest rate. more

Bunny Bond
A bunny bond is a type of bond that offers investors the option to reinvest coupon payments into
additional bonds at the same terms. more

Liability Matching Definition

Liability matching is an investment strategy that matches future assets sales and income streams
against the timing of expected future expenses. more

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