Managing re-investment risk is a very important aspect of financial planning. Re-investment risk refers to the risk of re-investing the periodical coupon or interest received from an investment at a potentially lower rate of interest than they are currently receiving. This applies not only to the future cash flows but also the principal amount on maturity. The periodical coupon receipts from Government securities, corporate bonds, interest from bank deposits, etc. can be re-invested on the date of receipt at the prevailing rate of interest . Hence, the investors are left with no option but to invest at the best available market rates. If the interest rate scenario is lower than what at the time of investment, then the investor loses money.
For example, Mr. A has made an investment in 2020 in a 10-year Corporate Bond at 10% interest, payable half yearly. The current interest rate for similar investment say above 5 years is 7%. A can invest the half-yearly coupon received only at 7% whereas the Principal amount continues to earn at 10%.
So the question is how to mitigate the potential loss on account of the likely lower rates on the future cash flows on the investments. A prudent investor needs to manage re-investment risks by proper financial planning and execution..
1. Long term investments
When one feels that the interest rates are going to soften in the medium to long term horizon, better to go for long-term investments so that the re-investment risk for the principal portion is insulated till the maturity while the future cashflows on account coupon payments are subject to re-investment, which need to be hedged separately.
2. Non-callable securities
“Call Option” bonds, generally the corporates do a buyback after a stipulated period, but before the maturity, in the event of the lower interest rate scenario. For the investor, the principal amount received can be re-invested at the current rate which will be lower than the existing coupon of the bond. Therefore, the investor should be aware of this fact while making such investments.
3. Zero coupon Bonds
These bonds are issued at a deep discount. The face value of the bond will be paid on maturity. The interest amount will be the difference between the maturity value and the issue price. Here the coupon of the bond (not zero) will be re-invested at the original interest rate as periodical payments are not made to the investor. But one has to keep in mind the liquidity risk, default risk and also interest in the event of an upward movement in interest.
4. Long Term Special Term Bank Deposits
Invest in Bank deposits where the interest and principal are paid on maturity. In this case, the periodical interest accrued is getting re-invested at the original rate of interest. Hence no re-investment risk when the rate of interest falls. On the contrary, if the interest goes up, the depositor has the option to prematurely close the deposit and re-deposit at a higher rate. Normally the bank charges a penalty for this, but the investor has to do a cost-benefit exercise before resorting to this option.
5. Floating Rate Bonds (FRBs)
Here the interest rates are re-set at regular intervals say half yearly. The re-pricing will be done at the current interest rates with or without a markup. Hence one need not worry about the movements in interest rates. If the interest rate outlook is positive, this type of investments are a perfect hedge.
6. Laddering
Create a Bond ladder. Under this the maturity date of the bonds are set in a staggered way so that the bonds mature on different dates. The tenor of the bonds are made like a ladder. So the re-investment also takes place at various dates at different interest rates minimizing the re-investment risk.
7. Diversified Portfolio
Include various class of fixed-income securities with different maturities in your portfolio. This will help to balance the risk associated with re-investment.
Managing future cashflows of Retail Investors
As discussed earlier, the periodical coupon receipts or interest are re-invested as and when received at the rate applicable on the date of receipt. In the event of an upward movement in the interest rates, the re-investment risk is zero. The potential loss in the event of a lower interest rate scenario can be mitigated by resorting to certain strategies. One strategy is to open a recurring deposit(RD) with a bank for a term which should match with the maturity of the investment. The periodic cashflows on the investment may be used for the instalments of the RD. The advantage is that the rate of interest of the RD remains constant till the maturity period irrespective of the volatility in the interest rate movements. In the event of a jump in the interest rate, the depositor can open another RD for higher rates for the remaining period of the investment by discontinuing the other one.. Any number of RDs can be opened but one has to manage . Investing the cashflows to equity oriented mutual funds through Systematic Investment Plan (SIP) is another option. There is nothing wrong in putting a small portion in a gold ETF which is also a perfect hedge. Alternatively one can have a mix of these depending on his primary goal of investment.
No doubt, investments in fixed-income securities are subject to re-investment risk. There is no one-touch solution for avoiding it. It can only be managed.
The writer is former SBI official and financial expert
