- Reinvestment risk is simply the probability that you will not be able to obtain the same rate of interest when the current bond repays the principal amount. A typical bond pays interest every six or 12 months and returns the principal amount, together with the last interest payment, upon expiration. A 10-year bond, with $1,000 face value and 10 percent interest issued on January 1, 2010, for instance, could pay interest twice a year, on January 1st and July 1st of every year. On January 1st, 2020, the bondholder would receive the last interest payment of $50, which is half of the 10 percent interest (since two payments are made each year), plus the $1,000 she originally invested, for a total of $1,050.
Shorts vs. Long Bonds
- The longer the remaining life of a bond, the greater the reinvestment risk associated with it. This is because it is harder to estimate what will happen in five years, as opposed to six months from now. Consequently, investors tend to make longer term investments either when they feel that market conditions are likely to deteriorate in the future, or when they are offered a higher rate of return for longer investment horizons. It is very hard to estimate what the prevailing market conditions will be in 10 years, and whether another investment with 10 percent return can be located at that point. If the present bond expires in three months, however, conditions will perhaps not have changed dramatically, and a similar opportunity could be located with ease.
- A crucial factor when talking reinvestment risk the liquidity. Some 10-year bonds leave the investor no choice but to tie up his money for the full 10 years, because they are very hard to sell. Such bonds are referred to as illiquid instruments. Due to a lack of sufficient potential buyers, it may be very hard to sell the bond before its expiration. The necessity to hold the bond until maturity would force the investor to put up with substantial reinvestment risk. A liquid bond, however, is one that can be sold relatively easily due to readily available demand. Even if such a bond won't expire soon, an investor can always sell it long before expiration and largely eliminate the reinvestment risk.
Funds vs. Individuals
- A diversified bond fund will face far less reinvestment risk than an individual with a limited portfolio. This is because a big fund will hold bonds of various maturities, some of which will effectively have turned into shorter term bonds, even if they were originally issued with a long-dated maturity. If a large fund buys several 10-year bonds every year, it will at some point end up with numerous bonds that were purchased seven, eight or nine years ago, which will now have one to three years till maturity. Since these bonds will repay the full principal soon, the fund will face, on average, less reinvestment risk than an individual with only a single bond, who will have to find a new investment for his entire portfolio when the single bond expires. Even a long-term fund, however, would have some degree of reinvestment risk.