When a person invests, there can be several categories of risk involved. One of those is referred to as reinvestment risk. This situation arises when invested funds generate revenue 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, her money will grow. This growth, usually in the form of interest or dividends, can be paid out to the investor or it can be 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 $100 United States Dollars (USD) CD and at the end of the year had $110 USD, 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, she would be reinvesting. At the end of this period, she may find that her $110 USD only earned $5.50 USD, which is a 5 percent rate of return. This investor, therefore, has fallen victim to reinvestment risk because her initial investment of $100 USD had double the rate of return as the reinvested funds.
There are a number of factors that can create this type of situation. Fluctuating interest rates is one example. In the case of bonds, reinvestment risk is commonly realized when loans are repaid early.
In these situations, investors often find that certain investment opportunities may be completely eliminated. Bonds are issued to help generate immediate revenue, generally for large businesses or government agencies. The funds used to purchase bonds will be repaid to bondholders at a later date. A period of many years is normally set for repayment.
During this span of time, the bondholder earns interest on the money owed to him. If, however, his bond was set to mature in 10 years, but all monies are repaid in eight years, he not only loses two years worth of interest but he must find another investment opportunity. The chance that he may earn less from the new opportunity than from his original bond is reinvestment risk.
