Reinvestment Risk: Overlooked & Under Appreciated
With interest rates still hovering around 5%, sitting in cash and collecting coupons is probably as appealing as it has been in many years. At the same time, the comfort of sitting in cash and collecting high-interest payments overlooks reinvestment risk, which has been underappreciated over the last decade.
What is reinvestment risk?
Reinvestment risk refers to the risk that future income will be reinvested in yields that are below current levels. For example, a 5% interest payment on today’s cash might be appealing but it could easily evaporate if rates start falling leaving an investor with limited options to reinvest proceeds and no potential upside in price appreciation.
How does it impact portfolios?
An easy way to highlight reinvestment risk is to look at some of the more recent environments characterized by high-interest rates and subsequent interest rate cuts. The example below compares a cash portfolio (money market fund) and a portfolio of high-quality intermediate-term bonds. For an investor who decided to stay in cash (orange line) rather than invest in bonds (blue line), the difference in outcomes becomes material as rates start falling. In those environments, bonds benefit from the appreciation in price whereas cash remains at the same level, which limits its future returns.
What are strategies to mitigate reinvestment risk?
A simple way to alleviate the risk is to move some of the cash to high-quality bonds with a bit longer maturity, especially for cash reserves that are not immediately needed. Increasing exposure to bonds allows an investor to lock in current yields for a longer time period and adds potential price appreciation if interest rates start falling. Without trying to guess the path of interest rates going forward, the reinvestment risk is likely higher compared to the previous few years as the Fed is signaling interest rate cuts throughout this year and inflation is trending in the right direction.
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