There are a number of key risks which investors need to be aware of; particularly credit risk, interest rate risk, market risk, amongst others. However, and this is common for the retail investor and to a lesser extent asset managers alike, reinvestment risk is often disregarded, or rather not given its due importance.
By definition, reinvestment risk is the risk/likelihood that the money investors receive from a bond investment, through bond interest payments as well as the payment of the bond principal upon maturity, are reinvested at a lower rate of interest than the rate at which the original bond was invested. As per text book definition, many investors are familiar with the term Yield to Maturity (YTM), but very few appreciate, or are aware of, one of the key assumptions of the YTM calculation.
By default, investors typically view the yield of a bond as a measure of their return on investment, assuming that that particular YTM is crystallised at the time of purchase for the duration of the bond. What is generally overseen is the assumption, that for the actual YTM to be achieved, the investor must be able to reinvest any coupon payments (upon receipt) at the computed Yield to Maturity. It must be understood however that, in today’s market scenario, any investment of coupons at a rate lower than the YTM of the bond will automatically translate to a lower overall generated yield and hence investors are subject and exposed to reinvestment risk.
It therefore comes as no surprise that the phenomenon of reinvestment rate risk is one of the key dilemmas investors and asset managers in particular have been facing in recent months, particularly following the bond rally in the aftermath of the 2008/2009 financial crisis, as bonds have been pretty much in bull market territory since February 2009.
Following the credit crunch in 2008, bond issuers had issued bonds and raised capital at yields ca 600 bps (on average) higher than those being issued today. It was commonplace for BBB rated bonds of high quality paper were issuing EUR denominated debt in spring of 2009 at yields of between 7%-8%. Most bonds, generally issued as either seven-year or 10-year benchmark bonds, had callable features embedded in them, which means that the bond issuers had the right to redeem the bond earlier (upon a pre-determined date schedule at known prices) if the market conditions were in their favour.
We are now at that juncture where most of those bonds have either matured (or are going to mature imminently) or are nearing their call dates. We have seen of late that bond issuers generally redeem their existing debt through available liquidity, rollover their maturing bonds at now more favourable/cheaper costs of financing (lower interest rates effectively translates into lower borrowing costs for bond issuers) or either redeem bonds prior to maturity, at their call dates in order to take advantage of lower financing costs.
Throughout the past eight years, bond investors within the high yield space are sitting on more than handsome gains (in terms of total returns). However, we must also appreciate that those investors who held a BBB rated bond in 2009 and whose bond is about to mature will struggle to come anywhere close to the 7%-8% yield of eight years ago, they might be lucky to get just 1.5%-2.0% for an eight-year BBB rated bond in EUR. This clearly epitomises where reinvestment risk is at the forefront of asset manager’s day-to-day dilemma and forms an integral part of their decision making process and asset allocation strategies.
Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.