Reinvestment risk is the probability that an investor will be unable to reinvest cash flows (e.g., coupon payments) at a rate comparable to the current investment's rate of return. Zero-coupon bonds are the only fixed-income instrument to have no investment risk since they issue no coupon payments.
Breaking Down 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, he will earn $4,000 annually rather than $6,000. Also, if interest rates subsequently increase and he sells the note before its maturity date, he loses part of the principal.
Callable Bonds and Reinvestment Risk
Callable bonds expose investors to reinvestment risk as the 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 willing to reinvest, the investor will do so receiving a lower rate of interest.
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 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.
Reducing Reinvestment Risk
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.