Don’t Let The Allure Of Bonds Mask Reinvestment Risk
With interest rates at their highest in decades, the allure of investing in bonds has returned. With that comes a lesser-known type of risk. It’s called “reinvestment risk.”
“The great thing about a bond is that they pay a consistent and reliable income. Most bonds have a maturity date, at which point the investor is repaid the original principal,” says Herman (Tommy) Thompson, Jr., Financial Planner at Innovative Financial Group in Atlanta. “Bonds can also be called, which means that the principal is repaid prior to the previously agreed upon maturity date. In both situations, the investor now has to find an investment that will replace the bond holding, but there is no guarantee that a bond of similar quality will be available with the same income. This is reinvestment risk.”
When most people consider investing risk, they think of the risk of loss of principal. The year 2022 provides ample evidence of this risk. The markets have further surprised investors this year by teaching them that this capital risk isn’t limited to stocks.
How is reinvestment risk different from interest rate risk?
Bonds can lose money, too. This happens whenever interest rates rise. This is known as “interest rate risk.” Since bond prices fluctuate with interest rates, there’s an inherent risk when owning bonds. It threatens the capital value of the bond. Of course, unlike stocks, you can avoid a capital loss in this asset class merely by holding your bond until it matures.
Reinvestment risk differs from capital risk. It pertains not to the principal investment but to the income derived, or expected to be derived, from that capital investment.
“Reinvestment risk is realized when an investor wants to reinvest coupon payments from existing investments and finds that the new market rate for the reinvestment is lower than the existing rate of return,” says Richard Gardner, CEO of Modulus in Scottsdale, Arizona. “This risk is most acute when considering callable bonds, making non-callable bonds, in addition to Z-bonds, one way to reduce reinvestment risk.”
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There’s no question that, like stock prices, interest rates go up and down. You cannot ignore this, despite seeing nearly two decades of relatively immovable (and historically low) interest rates. Right now, interest rates seem quite attractive if you’re a fixed income investor. The trouble is, what’s attractive today may not be available tomorrow.
“Reinvestment risk is the risk that, in the future, investors will receive a lower rate on their fixed income investments,” says Gregory DiMarzio, Vice President and Portfolio Manager at Rockland Trust in Worcester, Massachusetts. “It is a risk because the future rate may or may not fulfill their investment needs. Every investor must assess how long they want to invest their capital, and there is a trade-off between liquidity and the investment rate they are earning.”
When you invest in fixed income securities like bonds, you become a lender. In effect, you are lending money to the entity offering the bond. That loan generates interest that the borrower pays you. Once the loan expires, you’re now challenged with finding another borrower who will pay you the same interest amount.
“This is much easier to explain with an example,” says Avanti Shetye, Founder of Foolproof Financial Freedom in Ellicott City, Maryland. “Let’s say you own a mortgage-backed security with cash flows backed by mortgage payments from homeowners. When mortgage rates fall, homeowners tend to refinance their homes and return capital to their current lenders, who in turn return the capital to investors in those mortgage-backed securities. Investors not only lose the opportunity to earn interest on the returned capital, but also must reinvest that capital at current market rates, which are usually lower.”
Why should you be concerned with reinvestment risk?
Beyond the theoretical aspect, reinvestment risk carries very practical ramifications. You may count on those interest payments to pay expenses. If you can’t replenish those payments when the bond matures, it can inhibit your chosen lifestyle.
“Reinvestment risk can have a significant impact on the overall return of the investment,” says Tommy Gallagher, an ex-investment banker and the Founder of Top Mobile Banks who lives in Berne, Switzerland and Ann Arbor, Michigan. “It is important for investors to consider the current and expected future interest rate environment when investing in fixed-income securities in order to minimize the potential for reinvestment risk.”
Where there is risk, there is opportunity. And that’s precisely what those who have been stuck in low interest-bearing accounts see at the moment.
“It cuts both ways—in a rising rate environment, investors are taking advantage of rising rates to reinvest into more attractive yields,” says Rob Williams, Principal and Managing Director at Sage Advisory Services in Austin, Texas. “On the flip side, investors are vulnerable to earning less as they redeploy cash flows into a falling rate environment and increased call risk.”
Reinvestment risk is most severe for investors who have short-term objectives. Those with the long-term view have greater leeway.
“As long as your duration is shorter than your investment horizon, you will most likely either have your bonds recover and have to purchase lower yielding (higher priced) bonds, or you will have lower bond prices but are able to buy new bonds at higher prices,” says Rubin Miller, Chief Investment Officer at Perspective Wealth Partners in Austin, Texas. “Neither is really a big issue if the relationship between duration and investment horizon is properly designed.”
As interest rates rise, you may find bonds a more appealing investment. Be careful, though. Things may change, especially if a recession crops up.
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