There are a number of key risks assigned to a bond/fixed-income investment, namely credit risk, interest rate risk, market risk, among others.
However reinvestment risk is often disregarded, or rather not given its due importance by investors and asset managers alike.
Reinvestment risk by definition is the risk that the monies investors receive from a bond investment, namely in the form of periodical bond interest payments as well as the payment of the bond principal upon maturity, are reinvested at a lower rate of interest than the rate at which the original bond was invested.
Many investors are familiar with the term Yield to Maturity (YTM), but very few appreciate, or are aware of, one of the fundamental assumptions of the YTM calculation.
Investors typically view the YTM of a bond as a measure of their return on investment, assuming that that particular YTM is locked at a specific point in time for the lifetime of the bond. What is generally overseen is the assumption, that for the actually YTM to be generated, the investor must be able to reinvest any coupon payments (once received) at the computed Yield to Maturity.
Any investment of coupons at a rate lower than the YTM of the bond will automatically translate to a lower overall generated yield and hence investors will be subject to reinvestment risk.
The phenomenon of reinvestment rate risk is one of the key dilemmas investors and asset managers in particular have been facing of late, particularly in the wake of the bond rally witnessed after the Lehman Brothers debacle in 2008. True, there have been marked corrections since then, particularly in 2011, 2013 and end 2015 beginning 2016, but all in all bonds have been in bull market territory since February 2009.
In the aftermath of the financial crisis in 2008, a score of bond issuers approached the primary market in attempts to raise capital in the form of bonds. I recall when BBB rated bonds of high quality paper were issuing EUR denominated debt in Spring of 2009 at yields of between seven-eight per cent.
Most bonds, generally issued as either seven-year or 10-year benchmark bonds, had callable features embedded in them, which means that the bond issuers had the right to redeem the bond earlier (upon a pre-determined date schedule at known prices) if the market conditions were in their favour.
Eight years down the line, the large majority of those bonds have either matured (or are going to mature imminently) or are nearing their call dates. Bond issuers generally pay off their existing debt through available liquidity, rollover their maturing bonds at now more favourable/cheaper costs of financing (lower interest rates effectively translates into lower borrowing costs for bond issuers) or either redeem bonds prior to maturity, at their call dates in order to take advantage of lower financing costs.
True, one might argue that bond investors who were exposed to the bond market all along have locked in some pretty handsome gains. However, investors who held a BBB rated bond in 2009 and whose bond is about to mature will struggle to come anywhere close to the seven-eight per cent yield of eight years ago, they might be lucky to get just 1.5-two per cent for a 10-year BBB rated bond in EUR. And this is clearly a case where reinvestment risk is at the forefront of asset manager’s day-to-day dilemma.
Nowadays, in order to generate some form of yield, investors need to appreciate that everything comes at a cost, and in order to lock in higher yields, one needs to assume larger risks by going further down the credit rating ladder. Gone are the days when international BBB rated issuers issued bonds with yields in excess of five-six per cent, at least in the eurozone.
With yields expected to remain anchored at low levels, and the seven-10-year bonds issued in 2008 maturing over the next 12 months or so, investors need to grasp the concept of reinvestment risk and accept that we are currently living in a low-yield environment.
Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.
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