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Understanding Reinvestment Risk

  • Investment Manager
  • Blog post submitted on 19th May 2017
Mvblog

There are a number of key risks assigned to a bond/fixed-income investment, namely credit risk, interest rate risk, market risk, amongst others. However reinvestment risk is often disregarded, or rather not given its due importance by investors and asset managers alike.

Reinvestment risk by definition is the risk that the monies investors receive from a bond investment, namely in the form of periodical bond interest payments as well as the payment of the bond principal upon maturity, are reinvested at a lower rate of interest than the rate at which the original bond was invested. Many investors are familiar with the term Yield to Maturity (YTM), but very few appreciate, or are aware of, one of the fundamental assumptions of the YTM calculation.

Investors typically view the YTM of a bond as a measure of their return on investment, assuming that that particular YTM is locked at a specific point in time for the lifetime of the bond. What is generally overseen is the assumption, that for the actual YTM to be achieved, the investor must be able to reinvest any coupon payments (once received) at the computed Yield to Maturity. Any investment of coupons at a rate lower than the YTM of the bond will automatically translate to a lower overall generated yield and hence investors are subject and exposed to reinvestment risk.

The phenomenon of reinvestment rate risk is one of the key dilemmas investors and asset managers in particular have been facing of late, particularly in the wake of the bond rally witnessed after the Lehman Brothers debacle in 2008. True, there have been marked corrections since then, particularly in 2011, 2013 and end 2015 beginning 2016, but all in all bonds have been in bull market territory since February 2009.

In the aftermath of the financial crisis in 2008, a score of bond issuers approached the primary market in attempts to raise capital in the form of bonds. I recall when BBB rated bonds of high quality paper were issuing EUR denominated debt in Spring of 2009 at yields of between 7%-8%. Most bonds, generally issued as either 7-year or 10-year benchmark bonds, had callable features embedded in them, which means that the bond issuers had the right to redeem the bond earlier (upon a pre-determined date schedule at known prices) if the market conditions were in their favour.

Nine years down the line, the large majority of those bonds have either matured (or are going to mature imminently) or are nearing their call dates. Bond issuers generally pay off their existing debt through available liquidity, rollover their maturing bonds at now more favourable/cheaper costs of financing (lower interest rates effectively translates into lower borrowing costs for bond issuers) or either redeem bonds prior to maturity, at their call dates in order to take advantage of lower financing costs.

True, one might argue that bond investors who were exposed to the bond market all along have locked in some pretty handsome gains. However, investors who held a BBB rated bond in 2009 and whose bond is about to mature will struggle to come anywhere close to the 7%-8% yield of 8 years ago, they might be lucky to get just 1.5%-2.0% for a 10-year BBB rated bond in EUR. And this is clearly a case where reinvestment risk is at the forefront of asset manager’s day-to-day dilemma.

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