Reinvestment risk occurs when invested funds generate income that, once reinvested, will be subject to a lower rate of return. This risk is common in fixed income investments with set maturity dates, such as CDs and bonds, and can be caused by fluctuating interest rates or early loan repayments.
When a person invests, there may be several categories of risk involved. One of them is known as reinvestment risk. This situation arises when the invested funds generate income that once reinvested will be subject to a lower rate of return. This term is commonly used when considering fixed income investments that have set maturity dates, such as certificates of deposit (CDs) and bonds.
There are a few things that need to be understood before a person can fully understand reinvestment risk. To begin with, a person needs to know that when an investment is successful, his money will grow. This growth, usually in the form of interest or dividends, can be paid out to the investor or reinvested for further growth.
A person also needs to be familiar with the term “rate of return.” This refers to the amount that a certain investment earned. For example, if a person bought a $100 United States Dollar (USD) CD and had $110 USD at the end of the year, the rate of return would be 10 percent.
If the investor chose to allow the $110 USD to remain in the CD for another year, they would be reinvesting. At the end of this period, you may find that your $110 only earned $5.50, which is a 5 percent rate of return. This investor, therefore, has fallen victim to reinvestment risk because his initial investment of $100 USD had twice the rate of return of the reinvested funds.
There are a number of factors that can create this type of situation. Fluctuating interest rates are one example. In the case of bonds, reinvestment risk is commonly realized when the loans are paid off early.
In these situations, investors often find that certain investment opportunities can be eliminated entirely. Bonds are issued to help generate immediate income, usually for large companies or government agencies. Funds used to purchase bonds will be refunded to bondholders at a later date. A repayment period of many years is normally established.
During this period of time, the bondholder earns interest on the money owed to him. However, if his bond is due in 10 years, but all funds are paid in eight years, he not only loses two years of interest, but must find another investment opportunity. The possibility that he will earn less from the new opportunity than from his original bonus is reinvestment risk.
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