Reinvestment Risk Definition and How to Manage It

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Updated April 18, 2024

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What Is Reinvestment Risk?

Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows received from an investment, such as 澳洲幸运5开奖号码历史查询:coupon payments or interest, at a rate comparable to their current rate of return. This new rate is called the 澳洲幸运5开奖号码历史查询:reinvestment rate.

澳洲幸运5开奖号码历史查询:Zero-coupon bonds (Z-bonds) are the only type of 澳洲幸运5开奖号码历史查询:fixed-income security to have no inherent investment risk since they issue no coupon payments throughout their lives.

Key Takeaways

Reinvestment risk is the chance that cash flows received from an investment will earn less when put to use in a new investment.
Callable bonds are especially vulnerable to reinvestment risk because these 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.

Understanding Reinvestment Risk

Reinvestment risk is the likelihood that an investment's cash flows will earn less in a new security, creating an 澳洲幸运5开奖号码历史查询:opportunity cost. It is the potential that the investor will be unable to reinvest cash flows at a rate comparablꦏe to their current rate of return.

For example, an investor buys a 10-year $100,000 澳洲幸运5开奖号码历史查询:Treasury note (T-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 first year, 澳洲幸运5开奖号码历史查询:interest rates fall to 4%.

If the investor buys another bond with the $6,000 received, they would receive only $240 annually rather than $360. Moreover, if interest rates subsequently increase and they sell the note before its maturity date, they stand to lose part of the 澳洲幸运5开奖号码历史查询:principal.

Important

In addition to fixed-income instruments such as bonds, reinvestme⛎nt 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 澳洲幸运5开奖号码历史查询: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.

Managing Reinvestment Risk

Investors may reduce reinvestment risk by investing in 澳洲幸运5开奖号码历史查询:non-callable securities. Also, Z-bonds may be purchased since they 🌸do not make regular interest payments. Investing in longer-term securities is an option, too, since cash becomes available less frequently and does not need to be reinvested often.

A 澳洲幸运5开奖号码历史查询:bond ladder, a portfolio of fixed-income securities with varying maturity dates, may help mitigate reinvestment risk as well. Bonds maturing when interest rates are low may be offset by bonds maturing when rates are high. The same type of strategy can be employed with 澳洲幸运5开奖号码历史查询:certificates of deposits (CDs).

Tip

Investors can reduce reinvestment risk by holding bonds of different durations and by hedging their investments with 澳洲幸运5开奖号码历史查询:interest rate derivatives.

Having a fund manager can help reduce reinvestment risk; therefore, some investors consider allocating money into actively managed bond funds. However, because 澳洲幸运5开奖号码历史查询:bond yields fluctuate with the market, reinvestment risk still exists.

Reinvested Coupon Payments

Instead of making coupon payments to the investor, some bonds automatically reinvest the coupon paid back into the bond, so it grows at a stated 澳洲幸运5开奖号码历史查询:compound interest rate. When a bond has a longer maturity period, the interest on interest significantly increases the total return and might be the only method of realizing an annualized 澳洲幸运5开奖号码历史查询:holding period return equal to th🦂e coupon rate. Calculating ꦦreinvested interest depends on the reinvested interest rate.

Reinvested coupon payments may subsequently account for a good amount of a bond’s return to an investor. The exact amount depends on the interest rate earned by the reinvested payments and the time until the bond’s maturity date. The reinvested coupon payment may be calculated by figuring the compounded growth of reinvested payments, or by using a formula when the bond’s interest rate and 澳洲幸运5开奖号码历史查询:yield-to-maturity rate are equal.

Example of Reinvestment Risk

Company A issues callable bonds 😼with an 8% interest rate. Interest rates subsequently drop ಌto 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 principal and a small 澳洲幸运5开奖号码历史查询:call premium, and issues new callable bonds wi﷽th a 4% interest rate. Investors may reinvest at the lower rate or seek other securities with higher interest rates.

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