Concept
Reinvestment risk is associated with interest rate volatility. It refers to the uncertainty that an investor may not be able to invest the cash flows from an investment again at the same rate as that of the original investment.
Unless an investor uses his cash returns for consumption purpose, they are reinvested. It is impossible to predict the future rate accurately. At the time of reinvestment, it may be lower, subject to market conditions. This is the source of reinvestment risk. Besides, reinvestment risks also involve the chance that all the expected coupon payments may not be actually realized, in case the security is called away earlier.
Such risks play a significant role in bond investment and in any other type of short-term investments (e.g. certificates of deposits) which generate cash flows. However, it has importance only if you reinvest the cash returns in the same investment product.
Example
Say, you invest in a fixed income security which assures 10% return yearly and matures after 5 years. During these 5 years, if market condition changes and the 10% rate falls, say, to 4%, you have to reinvest your consecutive coupon payments at 4 % rate.
It is also possible that the issuer calls away the 10% securities and issues new securities at 4% rate. In such case, you’ll receive your principal amount but won’t earn as expected from interest income.
Optimal Strategy
If there are income streams to reinvest, there are reinvestment risks. Fortunately, you can devise some strategies to minimize or in the best case, avoid the risks.
- Invest as much as possible in non-callable securities.
- Invest in zero-coupon bonds.
- Invest in bonds which have the option to automatically reinvest the coupon payments at the already decided interest rate. Example: Implicit coupons.
- Practice laddering technique.
- Consider different types of investment.
Generally, securities with lesser reinvestment risks are lower paying securities. So, it’s better to make a trade-off calculation of risk and return.
