Question:  

Can you explain interest rate reinvestment risk?

Answer: 

Fixed income investors are faced with a situation of how to reinvest the cash flow and ultimately the initial principal of an investment. The risk is that they may earn a lower rate when funds are put to use in a new investment. 

Another way of explaining this is to use an analogy of a professional athlete at the prime of their career entering free agency and trying to decide between two contract offers. Because our grandson Josh’s high school baseball team just won their state championship, I’ll use a baseball pitcher negotiation example. 

Let’s say Josh receives two offers: the first for a 10-year contract for $200 million and the second for a 1-year contract at $25 million. The 10-year $200 million deal locks in a $20 million annual salary for the next decade. My left-handed pitching grandson would think that’s pretty nice. Yet, the $25 million is attractive as well, assuming all things are equal and his skill set improved over the next year, he might be able to negotiate a higher contract, or he may be injured or face competition from a new pitcher, and his deal could be less. That’s reinvestment risk. 

If Josh took the $25 million for one year, the risk is that he could be injured, have a bad season, or someone better may come up the ranks. If any of those things happened, he’d be kicking himself for not locking up the $20 million per year for the next ten years. Yes, if Josh had a great season that first year with the $25 million contract, he could possibly negotiate a longer-term contract at a higher amount, but there is uncertainty and risk. 

Fixed income investors face the same decisions when opting between a one-year bond and a 10-year bond. The one-year pitching contract and the one-year bond both come with considerable near-term “reinvestment risk.”  When you buy a bond that has a lifespan of just one year, you’re only locking in the yield that it earns for the next year. When you buy a bond that matures in 10 years, you’re locking in an annual return for the next 10 years. 

Just like the athlete that may have a bad year or get injured, bond yields could be lower a year from now, meaning that investors who chose to buy the one-year bond would have to reinvest into lower yielding investments next year. The investor who buys the 10-year bond has locked in a yield for the next 10 years, regardless of any changes in interest rates. 

Just like trying to predict an athlete’s future performance, we can only make educated guesses about where interest rates may be a year from now. What we do know is where rates are today. The athlete knows there is an offer to pay $200 million over 10 years they could lock in or a one-year $25 million deal allowing them to reenter the free agent market next year. 

A common misconception suggests that investing in shorter maturities is “more conservative.” There is no right or wrong answer here, but regardless of the length of investment maturity or contract, it’s a judgment call on the future of interest rates. Locking in longer may decrease reinvestment risk. 

For instance, if you had a crystal ball back in September of 1981 showing a 40-year overall interest rate decline, you would have likely been happy to lock in 10-year Treasury rates at 15.3%. You would’ve been even happier had you locked into the 30-year Treasury at 14.6%. The lower rate on the 30-year proved to be the better strategy because the 10-year Treasury reinvestment rate was 7.65%, and ten years after that it was 4.73%. 

If you think rates are going up, short maturities allow you to reinvest in the future at potentially higher rates. If you think rates are going down, locking up longer maturities may be the better strategy to optimize possibilities for long-term income. Long term approaches should measure all potential risks and rewards, including reinvestment risk. 

Investors today know that yields across the fixed income space are relatively attractive compared to rates going back years. The opportunity to lock in yields like this for an extended period of time may not last. For many investors, it may make sense to sign that 10-year contract today rather than the one-year deal. As fixed income investors, laddering maturities over several years is another technique to potentially mitigate reinvestment risk. Stay focused and plan accordingly.