The Economic Climate: A Tough Choice for Investors
Investors with a focus on fixed-income assets are getting a less than easy ride in the present economic climate. And with inflation still lingering as a major concern and central bank decisions under a microscope, there's two closely linked problems to worry about: interest rate risk and reinvestment risk. If you're to make any sense of these risks, then understanding the ins and outs is crucial - particularly if you're after stable returns in the US market.
Interest Rate Risk: What Happens When Rates Go Up
When we talk about interest rate risk, we're talking about the threat to the value of an investment - especially bonds and other fixed-income securities - when interest rates start going up. This is because if market rates increase, new bonds issued with a higher interest rate suddenly become the favorites, leaving older bonds that were snapped up at lower rates to look less attractive by comparison. If you want to sell that older bond before its due date, you'll have to offer it at a lower price than its face value to compensate the buyer for the lower returns they're getting compared to what's on offer elsewhere.
Take an example of an investor who invested in a 10-year Treasury bond back when rates were nice and low. If a year later new 9-year Treasury bonds are being launched with a 5% interest rate, then the original 3% bond is now worth less on the secondary market. It's price will have fallen to compensate for its lower returns relative to the new top rate on offer. This is a big problem for bonds that are out for longer - the longer they have to be in circulation, the more chance that interest rates will change, and their cash flows get discounted over a longer period of time. If you hold individual bonds to the very end, you can avoid the price fluctuations, but you'll still be missing out on the chance to have invested in a higher-yielding option.
Reinvestment Risk: The Trouble with Lower Returns
Reinvestment risk is basically the flip side - it's when the income generated by your investments gets reinvested at lower rates than what you originally got. This is a big deal in a falling interest rate environment. Sure, rates might be dropping so much that existing bond prices will rise for anyone selling them off before they mature - but at the same time your income is going to be hammered.
Consider someone who invested in a 5-year CD at a rate of 6% when interest rates were high. As that CD gets closer to maturity, if interest rates have plummeted to 3% in the meantime, then that investor is in a world of trouble. They'll be forced to put their principal back into the market at that much lower rate, and that will have a direct impact on their future income. For people relying on fixed income for living expenses, that's a major threat to their financial stability - and something anyone building a portfolio to provide a steady income needs to factor in.
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