Understanding Reinvestment Risk in Bonds

Reinvestment risk refers to the possibility that the income generated from investments, such as bond interest, will need to be reinvested at a lower interest rate than initially received. This situation can lead to reduced overall earnings if market rates decrease. A personal family anecdote illustrates this point vividly. In the early 1980s, during a period when money market certificate of deposit (CD) rates soared to 18% and 30-year U.S. Treasury bonds offered 16%, the speaker’s father chose not to invest in the latter despite the attractive rates. He enjoyed the higher returns from the 18% money market rate, assuming it would remain high. However, as time progressed, those earnings reinvested at lower and lower rates ultimately dwindled, exemplifying how choosing not to lock in a higher rate can lead to negative financial repercussions, especially highlighted during the global financial crisis. This anecdote serves as a cautionary tale about the potential downside of reinvestment risk when rates fall.