Fixed income investments typically have less risk than many other asset classes, but that is not to say fixed income is devoid of risk. In particular, many investors seem to be acutely aware of interest rate risk, yet blissfully unconcerned with reinvestment risk, an underappreciated hazard for decades.
Interest rate risk refers to the tendency of fixed income assets to decline in market value when interest rates rise. Many investors appear fixated on interest rate risk— likely because it typically reveals itself on investment statements in the form of lower bond values. However, because bonds mature at par (100 cents on the dollar) absent a credit event and most retail investors hold bonds to maturity, this investment statement markdown is just a transient occurrence; in most circumstances, the losses will fade as maturity approaches. Therefore, we believe investors may be better served focusing on a bond’s yield and/or cash flow.
Under-the-radar reinvestment risk
Reinvestment risk is the threat that the rate of return (i.e., cash flow) when it comes time to reinvest may be less than the return on the fixed income asset that is maturing. In our experience, reinvestment risk is a hazard that has been underappreciated, especially since interest rates generally have been declining for the greater part of 40 years.
If interest rates were guaranteed to decrease, the most logical fixed income investment strategy would be to lock in the most attractive interest rate for the longest period of time, which can typically be achieved by purchasing the longest-dated maturities. Unfortunately, no one has the prescience to consistently predict interest rates for an extended period. It is equally unfortunate that, despite their inability to predict interest rates, many investors, in our experience, have a latent bias that leads them to believe rates will rise, resulting in an unrealized loss
on their fixed income assets. Loss aversion may cause investors to focus on the potential temporary decline in the value of a bond (which is immaterial if the bond is held to maturity) while giving too little attention to reinvestment risk.
As a result, many investors delay purchases of longer term bonds, or only purchase short-term assets. However, from a historical perspective, short-term investors have frequently walked headlong into reinvestment risk by continually investing in progressively lower-yielding short-term fixed income assets. In essence, short-term investors have sacrificed the potential for greater wealth accumulation for the sake of investment flexibility and interest rate risk avoidance.
Teaser interest rates
Certain banks currently offer higher interest rates on savings accounts compared to various other fixed income options. Be that as it may, it is important to recognize that the bank interest rate can be modified at any time, exposing investors to reinvestment risk. Investors purchasing long-term fixed income assets are enhancing cash flow certainty (absent a credit event), whereas bankrate investors may be maximizing cash flow for a period of time but also exposing themselves to potentially lower savings rates in the future (reinvestment risk). It is our belief that most investors are better served by long-term reliability than by what can be riskier short-term cash flow maximization.
Count the cost
No one can foresee where interest rates may be headed, especially the further out one projects. But in our view, putting money to work is always beneficial, and in the current rate environment, adding duration rather than staying short appears to be the most prudent course
of action. Trying to time the market by waiting for rates to rise has proven costly for many investors in recent years. We believe that under most circumstances there are better strategies than staying short in anticipation of better investment opportunities that may never materialize, or in order to avoid the discomfort of a temporary loss on an investment statement.
Constructive strategies
While it is exceedingly difficult to predict the long-term direction of interest rates, we believe current Fed policies, future economic growth expectations, and historical precedent suggest interest rates will drift down from current levels. But regardless of the future direction, we believe there are better investment solutions than rigidly investing in short-term assets.
In our view, one superior strategy is to purchase bonds with staggered maturities to diversify the portfolio across a range of maturities in order to build what is known as a bond ladder. Another is to split purchases between long and short maturities; this is known as a barbell approach because investments are concentrated at both ends of the maturity spectrum. The disciplined use of either strategy ensures exposure to a significant portion of the yield curve, increases cash flow certainty, and reduces reinvestment risk, while still offering a degree of investment flexibility and mitigating interest rate risk.