Reinvestment rate risk is the chance that an investment will produce lower than expected income due to a future drop in interest rates. This risk is most closely associated with fixed-income investments, especially callable bonds. Shorter-term bonds also tend to have a higher reinvestment rate risk than long-term bonds. Reinvestment rate risk can be reduced by avoiding callable bonds and matching the maturity of a bond to the investor’s time horizon. Talk to a financial advisor to better understand reinvestment rate risk.
Reinvestment Rate Risk Defined
The promise of fixed-income investments such as corporate and government bonds is that an investor will receive a stable and predictable interest income for the life of the bond. This assured return means bonds carry less risk than some other asset classes such as equities, which may exhibit greater variability of return.
However, fixed-income investments do have certain specific kinds of risk. Default risk, or the chance that the bond issuer will fail to make the required payments of interest and principal, is one. When a bond issuer defaults, investors can lose not only their projected return but their entire invested capital.
Interest rate risk is also present with fixed-rate investments. This is the chance that rising interest rates will cause the prices of bonds to fall. This risk, also called market risk, can also cause bond prices to rise if interest rates fall. A fixed-income investment’s loss of value due to interest rate risk can exceed the anticipated return on the investment.
Reinvestment rate risk is another risk. This occurs when an investor must reinvest funds as a lower-than-anticipated rate in the future due to falling rates. Reinvestment rate risk is especially relevant with callable bonds. These are bonds that the issuer has reserved the right to redeem before the maturity date by paying bondholders the securities’ par value, also called the face value.
When a bond is called, the investor receives the face value of the bond but then must find a new place to invest it. If interest rates have declined since the investor purchased the bond, it may be difficult to find a bond of similar qualify that pays a similarly high rate of interest. This change of having to accept a lower rate of return is reinvestment rate risk.
Reinvestment Rate Risk Example
As an example of reinvestment rate risk, an investor could purchase a 10-year bond that pays 8% interest or $800 per year. When the bond matures, the investor will be paid the face value of the bond.
If interest rates have declined to 5% when the bond matures, however, purchasing a similar bond will provide only $500 a year in interest. If the 8% bond is called before maturity at a time when interest rates are lower, the same thing can happen.
Managing Reinvestment Rate Risk
Reinvestment rate risk is not the same for all types of fixed-income investments. In addition to being higher with callable bonds, reinvestment rate risk is higher with short-term bonds than with long-term bonds. Reinvestment rate risk is also higher when an investor has a shorter time horizon. For this reason, one way to manage reinvestment rate risk is to try to match the maturities of fixed-income investments with the holding period until the investor’s time horizon.
For instance, if the investor plans to cash out investment and use the funds for another purpose such as funding retirement in 10 years, purchasing fixed-income investments that mature in 10 years will reduce the reinvestment rate risk.
Another way to reduce reinvestment rate risk is to purchase only bonds that are not callable. This risk management strategy may require accepting a lower initial rate on the bonds, however, since non-callable bonds may pay a lower rate of interest than callable bonds.
Reinvestment rate risk is the risk that an investor will have to reinvest future cash flows at a lower return due to interest rate declines. Reinvestment rate risk is usually associated with fixed-income investments, especially callable bonds. This is also higher with shorter-term bonds,and when investors have shorter time horizons. Investors can fight reinvestment rate risk by investing in longer-term securities.
Tips for Investing
- A financial advisor can help you craft an investment strategy that matches your risk tolerance. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Diversification can help minimize risks including reinvestment rate risk while maintaining a high return. This investment strategy spreads investments among different classes of assets and holdings within asset classes. The investments in a well-diversified portfolio are unlikely to all experience a decline or an increase at the same time. This will increase the likelihood that an investor will enjoy steady returns.
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