Investor Corner/The asset classes/Debt Concepts
2.2.8 Reinvestment Risk
Reinvestment risk is the risk that when a bond matures or pays out interest, you are forced to reinvest that money at a lower rate than before, reducing your future income.
The risk of good news for borrowers, bad news for lenders
Reinvestment risk shows up most clearly when interest rates fall. A bond bought several years ago at 8% eventually matures, and the investor now has to reinvest that principal, but new bonds may only be offering 5%. The income stream that was locked in at 8% cannot be replicated at the same rate any longer, even though nothing about the investor's needs has changed.
Why shorter maturities carry more of this risk
Short-maturity bonds and liquid funds mature or roll over frequently, which means their income is repeatedly exposed to whatever rate happens to prevail at each renewal point. Longer-maturity bonds lock in a rate for longer, trading reinvestment risk for the interest-rate risk covered separately, since a bond's price will move more if it has a longer time left before that rate is finally reinvested.
A trade-off, not a flaw
Reinvestment risk and interest-rate risk pull in opposite directions across the maturity spectrum, and there is no single duration that eliminates both. Some investors manage this by laddering bonds of different maturities, so that only a portion of the portfolio faces reinvestment at any single point in time, smoothing out the effect of any one rate environment.
How PriLytics helps. PriLytics tracks the actual return earned on every debt holding over its full life, so shifts in income as instruments mature and roll over are visible rather than hidden. See holdings and returns.