Reinvestment risk

By Doug Drabik discusses fixed income market conditions and offers insight for bond investors.

Recently, a common request received by the fixed income desk has been from investors seeking a 1 year bond proposal. It is not an uncommon wish, especially during periods when the Treasury curve is inverted (shorter maturing bond rates are higher versus longer maturing bond rates). As I write this commentary, the 1 year Treasury rate is 4.22% versus the 10 year Treasury rate at 3.88%. Intuitively, why not invest “more conservatively” for one year at a higher rate than for 10 years at a lower rate?

Since January 1990, the 6 month T-Bill and 10 year Treasury note have been inverted (the 6 month T-Bill rate was/is higher versus the 10 year note) for approximately 650 days. If you bought the 1 year Treasury during an inverted period, on average, 1 year later, the 1 year Treasury rate was ~41% lower. If that average applied today, you could buy a 1 year Treasury today at 4.22% and in 1 year, you might expect the 1 year Treasury could be 2.49%. In contrast, if you bought a 10 year Treasury, you would have locked into a 3.88% yield each year for 10 years (3.88% in year one, 3.88% in year two, 3.88% in year three, etc.). This could also be labeled as reinvestment risk.

A common misnomer suggests that investing in shorter maturities is “more conservative.” There is no right or wrong answer here but regardless of the length of investment maturity, in essence it is a judgment call on the future of interest rates. If back in September of 1981, you had a crystal ball revealing a 40 year general interest rate decline, you would have been happy to lock into a 10 year Treasury at 15.3%. You would have been even happier had you locked into the 30 year Treasury at 14.6%. Why would you be happier with the lower rate? Because 10 years later, the 10 year Treasury reinvestment rate was 7.65% and ten years after that 4.73%! Locking in longer increases duration (price risk) but decreases reinvestment risk. Locking into a healthy interest rate may optimize your long term income.

If you think interest rates are going up, short maturities will allow you to reinvest in the future higher interest rates. If you think interest rates are going down, locking in to longer maturities may provide the better long term strategy. If you don’t know where interest rates are headed, laddering maturities in a range of good yields can mitigate reinvestment and duration risks while locking into desirable yields.

Yields are relatively attractive versus comparisons going back for years. Long term strategies should measure all potential risks and rewards, including reinvestment risk. Talk to your financial advisor about a strategy that works for you and your financial goals.

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.

To learn more about the risks and rewards of investing in fixed income, access the Securities Industry and Financial Markets Association’s Project Invested website and Investor Guides at www.projectinvested.com/category/investor-guides, FINRA’s Investor section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.