The Reinvestment Risk in Bond Investing
The vast majority of bond offerings are rather staid investments. You give your money to a government or corporation. You receive a steady flow of income, usually twice a year, for a certain number of years. Then, typically after a few years, you get your original money back. Sometimes you pay taxes. A broker usually takes a cut. Beginning and end of story.
The reason for bonds’ staid status is not only that they provide steady and predictable streams of income, but also that as a bondholder you have first dibs on the issuer’s money. A corporation is legally bound to pay you your interest before it doles out any dividends to people who own company stock.
If a company starts to go through hard times, any proceeds from the business or (in the case of an actual bankruptcy) from the sale of assets go to you before they go to shareholders.
However, bonds offer no ironclad guarantees. All investments carry some risk, such as reinvestment risk.
When you invest $1,000 in, say, a 20-year bond paying 6 percent, you may be counting on your money compounding every year. If that is the case — if your money does compound, and you reinvest all your interest payments at 6 percent — after 20 years you’ll have $3,262.
But suppose you invest $1,000 in a 20-year bond paying 6 percent and, after four years, the bond is called. The bond issuer unceremoniously gives back your principal, and you no longer hold the bond. Interest rates have dropped in the past four years, and now the best you can do is to buy another bond that pays 4 percent.
Suppose you do just that, and you hold the new bond for the remainder of the 20 years. Instead of $3,262, you are left with $2,387 — about 27 percent less money.
This is called reinvestment risk, and it’s a very real risk of bond investing, especially when you buy callable or shorter-term individual bonds. Of course, you can buy non-callable bonds and earn less interest, or you can buy longer-term bonds and risk that interest rates will rise. Tradeoffs! Tradeoffs! This is what investing is all about.
Note that one way of dealing with reinvestment risk is to treat periods of declining interest rates as only temporary investment setbacks. What goes down usually goes back up.