Reinvestment Rate

What Is a Reinvestment Rate?

The reinvestment rate is the amount of interest that can be earned when money is taken out of one fixed-income investment and put into another. For instance, the reinvestment rate is the amount of interest the investor could earn on the off chance that he purchased another bond while holding a callable bond called due in light of an interest rate decline.

Reinvestment rates are of particular concern to risk-opposed investors who invest in Treasury bills (T-bills), Treasury bonds (T-bonds), municipal bonds, Certificates of Deposit (CDs), preferred stocks with a stated dividend rate, and other fixed-income investments. These investors — who are often retirees or close to retirement — depend on the steady income given by their investments. While reinvesting in fixed-income securities is a common retirement portfolio strategy, it has risks, for example, interest rate risk.

Understanding Reinvestment Rate

The reinvestment rate is the return an investor expects to receive after reinvesting the cash flows from an investment. The return is communicated as a percentage and represents the anticipated profit the investor expects to make on the reinvestment of their money.

For instance, take an investor who has purchased a 5-year CD with an interest rate of 2%. At the finish of the term, the investor can reinvest their money in another CD at the going interest rate, they can take the cash without reinvesting, or they can reinvest in another sort of investment. In the event that they decide to reinvest in a bond offering a 3.5% yield, then their reinvestment rate is 3.5%.

Reinvestment and Interest Rate Risk

Anticipated reinvestment rates play a job in an investor's choices about what term to select while purchasing a bond or Certificate of Deposit (CD). An investor who expects interest rates to rise might select a shorter-term investment under the assumption the reinvestment rate when the bond or CD matures will be higher than the interest rates that can be locked for longer-maturity investments.

At the point when a bond is issued, and interest rates increase, an investor faces interest rate risk. Since bond prices fall when interest rates rise, an investor holding a fixed-rate bond may experience a capital loss on the off chance that the bond is sold before its maturity date. The more extended the time period until maturity, the greater the bond is subject to interest rate risk. Since a bondholder is given the face amount at maturity, bonds approaching the maturity date have little interest rate risk.

Investors can reduce interest rate risk by holding bonds of different durations and by hedging their investments with interest rate derivatives.

Reinvestment Risk

At the point when interest rates decline, the price of a fixed-rate bond increases. An investor might choose to sell a bond for a profit. Holding onto the bond might result in not earning as much interest income from reinvesting the periodic coupon payments. This is called reinvestment risk. At the point when interest rates decline, interest payments on bonds additionally decline. A bond's yield to maturity declines, lessening the total income received.

Reinvested Coupon Payments

Instead of making coupon payments to the investor, a few bonds reinvest the coupon into the bond, so it develops at a stated compound interest rate. At the point when a bond has a more drawn out maturity period, the interest on interest significantly increases the total return and might be the main method of understanding an annualized holding period return equivalent to the coupon rate. Calculating reinvested interest relies upon the reinvested interest rate.

Reinvested coupon payments might account for up to 80% of a bond's return to an investor. The exact amount relies upon the interest rate earned by the reinvested payments and the time period until the bond's maturity date. The reinvested coupon payment might be calculated by calculating the compounded growth of reinvested payments, or by utilizing a formula when the bond's interest rate and yield-to-maturity rate are equivalent.

Highlights

• Reinvestment rates can be negatively affected by interest rate risk, which is the potential for investment losses resulting from changes in interest rates.
• Reinvestment rates can likewise be impacted by reinvestment risk, which is the potential the investor will not be able to reinvest cash flows at a rate comparable to their current rate of return.
• The reinvestment rate is the return an investor expects to make after reinvesting the cash flows earned from a previous investment.
• The reinvestment rate is communicated as a percentage and represents the amount of interest that can be earned on a fixed-income investment.