Investors in fixed income securities, such as bonds, face reinvestment risk. The risk arises from the fact that the investor may have to invest the interim cash flows from the bonds at a lower interest rate than what he earns from the security. For example, if the security has a yield-to-maturity (YTM) of 10%, this assumes that the investor will be able to reinvest the coupon payments also at the same rate of 10%. Only then will the investor truly realize the YTM on his investment. However, this may not always be possible and investor may have to settle for a lower interest rate for these cash flows, and hence the reinvestment risk. Let’s say it’s a 10-year bond, and the first coupon is paid after 6 months. Then investor will have to ensure that this coupon payment continues to earn 10% for the next 9.5 years till the maturity of the bond.
The case of reinvestment risk can also be seen in callable bonds. The issuer will typically call back the bond in a falling interest rate environment as he would be able to come out with a new issue of bonds at lower interest rates. The investors (whose bonds are called back) will receive their principal earlier and will have to find new avenues for investment. Since it’s a falling interest rate environment, the investors will not be able to match their earlier proceeds.
Apart from regular bonds, the amortizable fixed income securities face even more reinvestment risk. In an amortizing security, the interest and a portion of principal is paid every month. If the interest rates in the market are falling, the principal may be prepaid prior to the scheduled payment dates, and the investor in such securities will have to reinvest at a lower interest rates. This is also cumbersome because the payments are received monthly and every month the investor will have to ensure the right investment to keep up the desired yield. In a rising interest rate environment, monthly proceeds may be advantageous because the investor can investment faster instead of waiting for 6 months. However, in a falling interest rate environment, this is a disadvantage to the investor.
Due to the presence of reinvestment risk in these securities, many investors prefer zero-coupon bonds because in zero-coupon bonds there are no coupon payments and hence no reinvestment risk. However, no coupon also means higher interest rate risk.