Higher short-term interest rates may make income from short-dated fixed income investments seem attractive, but reinvesting at similar yields upon maturity may be impossible if rates fall in the meantime. Find out how to approach reinvestment risk.
Reinvestment risk explained
Reinvestment risk is the risk that an investor will have to reinvest the coupon, principal and/or interest received from an investment at a potentially lower rate than they are currently receiving. This typically occurs when interest rates decrease during the investment horizon of an investor.
Reinvestment risk is frequently associated with fixed income investments, but it can apply to any investment that has cash flows or matures during the investor’s investment horizon.
Changes in interest rates are also associated with interest rate risk. This represents the potential for investment losses due to the impact of interest rate changes on the valuation of the investment. For example, an increase in interest rates could potentially reduce the price of a fixed-rate bond, which could result in a capital loss were the bond sold before maturity. Of course, if the bond is held to maturity, it will still redeem at par.
Interest rate risk differs from reinvestment risk in that it reflects the impact of interest rate movements on the value of an investment, whereas reinvestment risk is the risk of not achieving the same yield on reinvested funds.
Reinvestment risk in portfolios
Reinvestment risk can impact overall return of investments. In periods of higher interest rates, investors should be mindful of not only aligning portfolios for the near-term, taking advantage of higher short-term yields, but also anticipate the potential impact of any changes in interest rates over their full investment horizon.
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.
When the yield curve is inverted, it means that the rate of return on shorter-dated securities is above that of longer-dated securities. This can occur when short-term interest rates are high but expected to fall.
US TREASURY YIELD CURVE, JUNE 2023
Source: Global Investment Lab using Bloomberg. US Treasury Yield curve as at 14th June 2023. For illustrative purposes only.
In the scenario of an inverted yield curve, it can be tempting to invest more in shorter-dated securities in order to earn the higher yields on offer. However, this investing strategy runs the risk that the yields on offer when these shorter dated securities mature, will be lower than those available today.
A historical illustration
There are many historical examples of the impact of reinvestment risk. Here, we go back to the Fed Funds peak of December 2000 and compare the returns of an investor who purchased a 10-year US Treasury bond and held it to maturity, with those of an investor who purchased a 3-month US T-bill at the same time, reinvesting the proceeds in a new 3-month US T-bill at the prevailing market rate each time the current one matured over the same period.
The investor who purchased the 10-year US Treasury bond in December 2000 would have locked in a yield to maturity of 5.11% p.a. The investor who purchased 3-month US T-bills would have received a yield of 5.90% p.a. on the first T-bill, however, due to subsequent changes in yields, by investing in a series of 3-month T-bills, over the 10-year period to December 2010 they would only have achieved an overall annualized return of 2.29%*.
Rates can change rapidly
US GOVERNMENT BOND YIELDS AGAINST THE FED FUNDS TARGET RATE SINCE 1983
Source: Global Investment Lab using Bloomberg. Monthly data June 1983 to May 2023. For illustrative purposes only. Past performance is no guarantee of future results. Real results may vary.
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.
Mitigating reinvestment risk
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.
Reinvestment risk is the risk that the same level of income is no longer available when it’s time for cash from coupon payments and investments maturing, to be reinvested.
In a higher rate environment, the yields on shorter-term instruments can seem attractive, however by investing for a longer period while higher rates are available, investors may risk foregoing returns over a longer horizon.
Strategies that may help to manage reinvestment risk include:
Evaluating current and future interest rate environments before selecting investments
Increasing exposure to longer duration securities
Selecting instruments with less exposure to reinvestment risk
Actively managed bond funds