The chart above depicts the historical Fed Funds target rate since 1983 alongside the yields of 3-month US T-Bills and 10-year US Treasuries. We can see that the shorter-dated yields tend to be closely tied to the Fed Funds rate and react rapidly to any changes in it, unlike the longer-dated yields, which are tied to the longer-term economic outlook. While a higher rate environment may make short-dated instruments attractive in the immediate term, not locking in higher rates for a longer period while these are available may lead investors to forego returns over a longer horizon.
Reinvestment risk due to its uncertain nature, being tied to future evolutions of interest rates, can be overlooked by investors focusing on short-term returns.
However, reinvestment risk has the potential to significantly impact overall returns over longer-term horizons, and investors should be careful to evaluate both the current and future interest rate environments when deciding how to invest.
Investors looking to mitigate their exposure to reinvestment risk should:
- Be aware of which types of investments have more exposure to reinvestment risk
- Consider increasing portfolio allocation to longer duration bonds
- Assess actively managed bond exposure
- Make sure to consider future interest rate environment as well as current one when deciding how to invest
Investments with lower exposure to reinvestment risk include longer-term bonds, zero-coupon bonds, and non-callable bonds.
Longer-term bonds lock in yields for a longer period, thereby giving a level of certainty to investors seeking a stable stream of income.
Zero-coupon bonds don’t make interest payments, but instead trade at a discount, rendering full face value at maturity. Their lack of periodic payments removes the risk of potentially needing to reinvest coupons at lower rates.
Non-callable bonds cannot be redeemed early by the issuer. They tend to have less reinvestment risk than callable bonds because the principal cannot be repaid prior to the maturity date.
Laddered exposure involves holding a series of securities with staggered maturity dates. A laddered portfolio will invest in short-, medium- and longer-term bonds, such that only a percentage of the bonds will mature in the same interest rate environment. In this way investors retain exposure to some shorter-dated securities, but reinvestment risk may be managed through diversification.
As well as dispersing risk along the interest rate curve, laddering can be used to provide a steady stream of income and to manage portfolio duration in line with the investor’s objectives.
Actively managed bond funds by fund managers,may help to manage the impact of interest rate and yield curve changes by making active decisions around security selection and portfolio duration positioning on an ongoing basis.
FAQs
Methods to mitigate reinvestment risk include the use of non-callable bonds, zero-coupon instruments, long-term securities, bond ladders, and actively managed bond funds.
How do you manage reinvestment risk? ›
Methods to mitigate reinvestment risk include the use of non-callable bonds, zero-coupon instruments, long-term securities, bond ladders, and actively managed bond funds.
How can reinvestment risk be avoided? ›
Having some longer-maturity bonds or bond funds may help mitigate reinvestment risk in this situation. Adding duration with longer maturity holdings may help generate capital appreciation when rates fall. However, if rates have not yet peaked, this move would increase your interest rate risk.
How reinvestment risk may be avoided if an investor purchases? ›
By investing in bonds with maturities of between 3 and 10 years, or in a bond mutual fund or ETF, with durations typically found in the US Aggregate Bond Index, you can avoid the risks posed by holding too much cash, and instead continue to earn the level of return you seek from your portfolio.
What is the difference between price risk and reinvestment risk? ›
Price risk is positively correlated to changes in interest rates, while reinvestment risk is inversely correlated.
What is the greatest level of reinvestment risk? ›
The CFAI states that "The bond with the highest coupon and the longest maturity will have the greatest reinvestment risk".
What is a good reinvestment rate? ›
Deciding How Much to Reinvest
And, of course, there are operating expenses and overhead costs that keep it going. By reinvesting profits, however, you can drive growth and increase revenue. As noted, conventional wisdom suggests reinvesting 20% to 30%—some recommend up to even 50%—of profit back into your business.
Do strips avoid reinvestment risk? ›
A strip bond has no reinvestment risk because there are no payments before maturity. On the maturity date, the investor is repaid an amount equal to the face value of the bond.
What increases reinvestment risk? ›
Reinvestment risk is often of greater concern when the yield curve is inverted. The yield curve plots the yield of securities against their time to maturity. This is usually upward sloping, reflecting the higher rate of return required in return for locking up funds for a longer period.
What is the difference between reinvestment risk and refinancing risk? ›
Reinvestment risk refers to the risk of a lower return from the reinvestment of proceeds that the Group receives from prepayments and repayments of its loan portfolio. Refinancing risk is the risk of refinancing liabilities at a higher level of interest rate or credit spread.
The IRR calculation assumes that the future cash flows will each be reinvested, to the horizon, at the project's calculated IRR rate. This reinvestment rate assumption is most likely unrealistic because, in fact, the firm may choose to invest interim cash flows in some other project or investment.
What is reinvestment risk most closely associated with? ›
In practice, reinvestment risk is most common in the fixed income market for securities such as corporate bonds, where the issuer is obligated to pay interest to the investor per the lending agreement.
Is call risk the same as reinvestment risk? ›
Callable bonds are akin to call options, where the issuer has the right to call the bond before maturity. Call risk is similar to reinvestment risk, where the investor risks having to reinvest at a lower interest rate.
Which category of investor will experience the highest reinvestment rate risk? ›
Pension funds, which typically have long-term investment horizons and are focused on meeting the future pension obligations of their members, will experience the highest reinvestment rate risk.
Do treasury receipts have reinvestment risk? ›
Treasury Receipts long term, zero coupon bonds that pay interest only at maturity. There is no interest to reinvest during the life of the bond, therefore, STRIPS do not experience reinvestment risk.
Which type of bond will not be affected by reinvestment risk? ›
Conventional Treasury Bonds are subject to this risk, since interest payments are received semi-annually. Treasury Bills are not subject to reinvestment risk because they are essentially short term "zero-coupon" obligations.
How do you treat reinvested dividends? ›
Key Takeaways
Cash dividends are categorized as qualified or ordinary. Qualified dividends are taxed at lower rates than ordinary dividends, which are considered ordinary income. Reinvested dividends are treated as if you actually received the cash and are taxed accordingly.
How to manage unsystematic risk? ›
Unsystematic risk can be mitigated through diversification, and so is also known as diversifiable risk. Once diversified, investors are still subject to market-wide systematic risk. Total risk is unsystematic risk plus systematic risk.
How do you treat dividend reinvestment in accounting? ›
Important considerations with DRIPs
Each purchase is considered a new tax lot (think of it just like any other share an investor might purchase) with its own basis and purchase date. The dividend income is reported on a 1099-DIV for taxable accounts, regardless of whether it's reinvested or not.
How do you manage interest rate risk? ›
Safer investments: The safest option for investors who are trying to reduce the risks associated with interest rates is to invest in bonds and certificates, which have short maturity tenure. Securities with short maturity tenure are less susceptible to fluctuations in interest rates.
