Interest Rate Risk Vs. Reinvestment Rate Risk

Interest rates may fluctuate wildly, which exposes fixed income securities to risk.

Fixed income investments offer lower amounts of risk, relative to equities. Fixed income investors make loans out to borrowers and receive interest payments in return. Fixed investments are, however, associated with interest and reinvestment rate risks.

Identification

Bonds and certificates of deposit identify financial products that pay out interest. Interest rate risks describe adverse interest rate movements. Reinvestment risk defines the potential for reinvesting interest earnings into securities that offer lower returns.

Features

Debt securities pay interest at either fixed or variable rates. Fixed interest rates remain constant throughout maturity. Rising interest rates cause older fixed debt securities to lose value because larger payments will be offered upon newly issued debt. Variable interest securities expose investors to risk when interest rates fall because debt earns less interest.

Considerations

Mortgage bonds are very susceptible to reinvestment rate risk. Homeowners refinance into new loans that pay off old mortgages when interest rates fall. Investors must then reinvest the mortgage principal amid a lower interest rate environment.

Misconceptions

The Federal Reserve Board implements monetary policy to influence interest rates. However, markets may not react to Fed transactions in the short term.

Risks

Debt securities are privy to business risks. Rising interest rates increase chances for default as unprofitable companies struggle to make payments.

References

• Federal Reserve Board: Federal Open Market Committee
• Investopedia: Interest Rate Risk
• Investopedia: Reinvestment Risk

Resources

• Investopedia: Bond Basics