It is quite common for investors to view the risk of an underlying bond investment from different angles, be it credit risk, interest rate risk, market risk, among others.

The term risk can be easily interchanged and at times misused, as it is not necessarily clear at all times which type of risk an investor would be making reference to.

All types of risks are important, and investors ought to know the relevance of each. However, over recent years speaking to retail investors, and to a lesser degree, asset managers, the concept of reinvestment risk is often overseen and not given its due importance.

Quite an intricate concept to grasp but put simply, the reinvestment risk on a bond is the assigned probability that the money investors receive from a bond investment, generally through bond interest payments and/or via the payment of the bond principal upon maturity and or (early) redemption, are reinvested at a lower rate of interest than the rate at which the original bond was invested.

Many investors and asset managers alike are familiar with the term Yield to Maturity (YTM), but very few are aware of and appreciate a key assumption of the YTM calculation.

The YTM is considered as a long term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return (IIR) of a bond held to maturity with all interest payments reinvested at the same rate.

It is commonplace for an investor to typically view the YTM of a bond as the key measure of their return on investment, based on the fundamental key assumption that that particular YTM is crystallised at the time of purchase for the duration of the bond, and hence the bond investment is not sold till maturity date.

What is however generally not looked into is the assumption, that for the actual YTM to be achieved, the investor must be in a position to reinvest any coupon payments (upon receipt) at the computed Yield to Maturity at the same rate.

It must therefore be understood however that, within context of a market scenario we are faced with today, any investment of coupons at a rate lower than the YTM of the bond will inevitably translate into a lower overall generated yield and hence investors are subject and exposed to reinvestment risk.

It is this particular point, tying in with the phenomenon of reinvestment rate risk, which leads investors into a dilemma.

Following the bond rally post Lehman crisis in 2009, where bonds were being issued at high levels of interest rate, we have witnessed (almost 36 months) whereby bond issuers were refinancing bonds at significantly lower rates of interest, mainly as a result of the significant tightening of bond spreads brought about by quantitative easing.

10 years after the Lehman crisis, most of those bonds issued in the aftermath of the market downturn, have either matured (or are going to mature imminently) or are nearing their call dates.

It comes as no surprise that bond issuers have been generally redeeming 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.

What is happening also, is that whilst default rates have been historically low in recent months, a large number of bond issuers have taken advantage of lower rates of financing by increasing their borrowings, re-leveraging their balance sheets.

By means of a simple example, 10 years ago, a 10-year BBB rated bond would have been issued at a YTM of 7%-8% - today you’d be lucky to get 1.5%-2% on a similar bond denominated in EUR.

Clearly, reinvestment risk is a concept which should not be taken lightly, especially given the fact that we are now at a point of inflexion, as far as benchmark rates and credit spreads are concerned.

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 are 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.