The chart above depicts the historical Fed Funds target rate since 1983 alongside the yields of 3-month US T-Bills and 10-year US Treasuries. We can see that the shorter-dated yields tend to be closely tied to the Fed Funds rate and react rapidly to any changes in it, unlike the longer-dated yields, which are tied to the longer-term economic outlook. While a higher rate environment may make short-dated instruments attractive in the immediate term, not locking in higher rates for a longer period while these are available may lead investors to forego returns over a longer horizon.
Reinvestment risk due to its uncertain nature, being tied to future evolutions of interest rates, can be overlooked by investors focusing on short-term returns.
However, reinvestment risk has the potential to significantly impact overall returns over longer-term horizons, and investors should be careful to evaluate both the current and future interest rate environments when deciding how to invest.
Investors looking to mitigate their exposure to reinvestment risk should:
- Be aware of which types of investments have more exposure to reinvestment risk
- Consider increasing portfolio allocation to longer duration bonds
- Assess actively managed bond exposure
- Make sure to consider future interest rate environment as well as current one when deciding how to invest
Investments with lower exposure to reinvestment risk include longer-term bonds, zero-coupon bonds, and non-callable bonds.
Longer-term bonds lock in yields for a longer period, thereby giving a level of certainty to investors seeking a stable stream of income.
Zero-coupon bonds don’t make interest payments, but instead trade at a discount, rendering full face value at maturity. Their lack of periodic payments removes the risk of potentially needing to reinvest coupons at lower rates.
Non-callable bonds cannot be redeemed early by the issuer. They tend to have less reinvestment risk than callable bonds because the principal cannot be repaid prior to the maturity date.
Laddered exposure involves holding a series of securities with staggered maturity dates. A laddered portfolio will invest in short-, medium- and longer-term bonds, such that only a percentage of the bonds will mature in the same interest rate environment. In this way investors retain exposure to some shorter-dated securities, but reinvestment risk may be managed through diversification.
As well as dispersing risk along the interest rate curve, laddering can be used to provide a steady stream of income and to manage portfolio duration in line with the investor’s objectives.
Actively managed bond funds by fund managers,may help to manage the impact of interest rate and yield curve changes by making active decisions around security selection and portfolio duration positioning on an ongoing basis.
