What Is a Reinvestment Rate?
Let me explain to you what a reinvestment rate is—it's the interest you can earn when you take money from one fixed-income investment and put it into another. For instance, if you're holding a callable bond that's called due to falling interest rates, the reinvestment rate is what you'd get by buying a new bond with that money.
This matters especially to risk-averse investors like retirees or those nearing retirement who put their money into Treasury bills, Treasury bonds, municipal bonds, Certificates of Deposit, preferred stocks with fixed dividends, and similar fixed-income options. You rely on the consistent income these provide, but remember, reinvesting in them as a retirement strategy comes with risks, particularly interest rate risk.
Key Takeaways
- The reinvestment rate is the return you expect after reinvesting cash flows from a prior investment.
- It's expressed as a percentage, showing the interest on a fixed-income investment.
- Interest rate risk can negatively affect reinvestment rates, leading to potential losses from rate changes.
- Reinvestment risk means you might not reinvest cash flows at a rate matching your current return.
Understanding Reinvestment Rate
The reinvestment rate is what you anticipate earning when you reinvest cash flows from an investment. It's given as a percentage and reflects the profit you expect from putting that money back to work.
Consider this example: suppose you buy a 5-year CD at 2% interest. When it matures, you can reinvest in another CD at the current rate, take the cash, or choose a different investment. If you pick a bond yielding 3.5%, that's your reinvestment rate—3.5%.
Reinvestment and Interest Rate Risk
Your expected reinvestment rates influence decisions on investment terms for bonds or CDs. If you think rates will rise, you might go for a shorter term, assuming you'll get a better rate later than locking in a long-term one now.
When bonds are issued and rates go up, you face interest rate risk. Bond prices drop as rates rise, so selling a fixed-rate bond early could mean a capital loss. Longer maturities increase this risk, but bonds close to maturity have minimal exposure since you get the face value back.
You can mitigate interest rate risk by holding bonds with varied durations or using interest rate derivatives for hedging.
Reinvestment Risk
When rates fall, fixed-rate bond prices rise, and you might sell for a profit. But holding on could mean lower interest income from reinvesting coupons—this is reinvestment risk. Declining rates lower bond interest payments and yield to maturity, cutting your total income.
Reinvested Coupon Payments
Some bonds reinvest coupons back into the bond itself, growing it at a compound rate instead of paying you directly. For longer maturities, this interest on interest boosts total returns significantly and might be key to matching the coupon rate in annualized returns. Calculating this depends on your reinvestment rate.
Reinvested coupons can make up to 80% of your bond return, based on the rate for those payments and time to maturity. You calculate it via compounded growth or a formula when the bond's interest and yield-to-maturity match.
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