What is 'Reinvestment Risk'
Reinvestment risk is the risk that future coupons from a bond will not be reinvested at the prevailing interest rate from when the bond was initially purchased. Reinvestment risk is more likely when interest rates are declining and affects the yield to maturity of a bond, which is calculated on the premise that all future coupon payments will be reinvested at the interest rate in effect when the bond was first purchased. Zero-coupon bonds are the only fixed-income instruments to have no reinvestment risk since they have no interim coupon payments.
BREAKING DOWN 'Reinvestment Risk'
Reinvestment risk occurs when an investor cannot reinvest cash flow from another security at the same interest rate as the security’s current rate of return. 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, when the 10 years are up, interest rates are at 4%. If the investor buys another 10-year $100,000 Treasury note, he will receive $4,000 annually rather than $6,000, a difference of $2,000 in yearly income. Also, if interest rates rise after purchasing the note, and the investor sells the note before its maturity date, he loses part of the principal.
Callable Bonds and Reinvestment Risk
Reinvestment risk may be greater with callable bonds than other types of bonds. Bonds are typically called when interest rates drop below the rates at which the bonds were issued. The bonds are replaced with new callable bonds issued at the lower rate. The business or government entity then saves money on interest payments. Investors lose money on unpaid interest and must reinvest in other securities at a lower rate.
For example, Company A issues callable bonds with an 8% interest rate. When rates drop to 6%, the company calls the bonds, pays each investor his principal and a small call premium, and then issues new callable bonds with a 6% interest rate. Investors may invest at the lower rate of return or look elsewhere for securities bearing higher interest rates.
Reducing Reinvestment Risk
Investors may reduce reinvestment risk by investing in noncallable securities. Zero-coupon bonds may be purchased, as 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 reinvestment as often.
A bond ladder, or purchasing bonds with diverse maturity dates, may help mitigate reinvestment risk. Bonds maturing when interest rates are down may be offset by bonds maturing when rates are up.
Since having a fund manager can help reduce reinvestment risk, an investor may put money into actively managed bond funds. However, because bond funds’ yields fluctuate with the market, reinvestment risk still exists.