The reinvestment rate is the amount of interest that can be earned when money is taken out of one fixed-income investment and put into another. For example, the reinvestment rate is the amount of interest the investor could earn if he purchased a new bond while holding a callable bond called due because of an interest rate decline.
Breaking Down Reinvestment Rate
Anticipated reinvestment rates play a role in an investor’s decisions about what term to select when purchasing a bond or CD. An investor who expects interest rates to rise might select a shorter-term investment under the assumption the reinvestment rate when the bond or CD matures will be higher than the interest rates that can be locked for longer-maturity investments. When a bond is issued, and interest rates increase, an investor faces interest rate risk. Since bond prices fall when interest rates rise, an investor holding a fixed-rate bond may experience a capital loss if the bond is sold before its maturity date. The longer the time period until maturity, the greater the bond is subject to interest rate risk. Because a bondholder is given the face amount at maturity, bonds nearing the maturity date have little interest rate risk.
When interest rates decrease, the price of a fixed-rate bond increases. An investor may decide to sell a bond for a profit. Holding onto the bond may result in not earning as much interest income from reinvesting the periodic coupon payments; this is called reinvestment risk. When interest rates decline, interest payments on bonds also decrease. A bond’s yield to maturity declines, reducing total income received.
Reinvested Coupon Payments
Instead of making coupon payments to the investor, some bonds reinvest the coupon into the bond, so it grows at a stated compound interest rate. When a bond has a longer maturity period, the interest on interest significantly increases the total return and maybe the only method of realizing an annualized holding period return equal to the coupon rate. Calculating reinvested interest depends on the reinvested interest rate.
Reinvested coupon payments may account for up to 80% of a bond’s return to an investor. The exact amount depends on the interest rate earned by the reinvested payments and the time period 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 yield-to-maturity rate are equal.