The risk of reinvestment of a bond refers to the possibility that the investor can not find a bond with the same or better profile when it will expire. Long-term bonds have higher risk of reinvestment than bonds with shorter terms. A variety of bond funds can alleviate this risk to some extent.
Risk to re-invest
The risk of reinvestment is the possibility that you will not get the same interest rate when the current bonus returns to pay the principal amount. A typical bond pays interest every six or twelve months and returns the principal amount, including the final repayment of interest in the period. For example, a 10-year bond, with a nominal value of US $ 1,000 and a 10 percent interest rate published on January 1, 2010, may be paid twice a year, on January 1 and July 1 per year. On January 1, 2020, bond holders will receive a final interest payment of US $ 50, which is half the stake of 10 percent (since two payments are made annually), including US $ 1,000 initially invested, totaling US $ 1,050.
Long vs. short bonds
The longer the life of a bond, the greater the risk of reinvestment associated. This is because it is harder to estimate what will happen in five years, instead of six months. As a result, investors tend to make longer investments, if they feel that market conditions are likely to worsen in the future, or when they are offered a higher rate of return from longer investment horizons. It is difficult to estimate how much of the existing market conditions are in 10 years, and if another investment with a 10 percent return is found at that point. If the current bonus ends within three months, however, the conditions may not change significantly, and a similar opportunity can be easily seen.
An important factor when talking about the risk of reinvestment is liquidity. Some 10-year bonds do not leave investors with any other option than to tie their money for 10 years, because it’s very difficult to sell. These bonds are called instruments that are not safe. Due to the lack of sufficient potential buyers, it can be difficult to sell the bond before expiring. The need to save it until it expires forces investors to face the huge risk of reinvestment. A liquid bond, however, is one that can be sold quite easily due to the usable demand. Even if it does not expire soon, an investor can always sell them long before the maturity and to a large extent eliminate the risk of reinvestment.
Funds vs.. individual
A diversified bond fund will face the risk of reinvestment by more than one individual with a limited portfolio. This is because a large fund will maintain funds of various maturities, some of which have become shorter-term bonds effective, although they were originally provided with long-term maturities. If a large fund buys some 10-year bonds per year, at one point it will end with many bonds purchased seven, eight or nine years ago and now will have one to three years will expire. Because these bonds will soon pay full capital, they will have an average lower risk of reinvestment than someone with a single bond, who need to find new investments for their entire portfolio when it will be lost can. Even a long-term fund, however, has a certain degree of risk of reinvestment.