Straight Out of a Finance Textbook

This semester, I’m the Graduate Teaching Assistant for an undergraduate Financial Markets class. I just wrapped up grading their second exam of the semester. As I was reading through 23 interpretations of interest rate and reinvestment risk, I was reminded that sometimes the basics can be the most relevant.

Both concepts are easiest to explain in terms of bonds because they have set face values, set coupons, and set maturity dates. When you buy a bond, you know exactly what your payments are going to be, the duration of the payments, and the principle you’ll get back at the end.

Interest rate risk can show itself when you have to sell your bond before maturity. If interest rates have risen since you bought the bond, it will push down the current price of your bond.

As interest rates change, bond prices adjust on the open market. If new issuances have a higher interest rate, no one is going to pay full face value for your bond with a lower yield. For you to unload your bond and free up your cash, you’ll have to drop your price until your bond’s yield matches the market, creating a capital loss for yourself.   

Reinvestment risk shows up when your bond matures and you want to roll the money into a new bond. If you’re faced with lower rates than your original bond, you should have selected a longer maturity on your initial investment. You’re a victim of reinvestment risk because rates went down.

But We’re Dividend Investors

What’s going on in the bond world directly affects us dividend investors. At the end of the day, most of us are income investors. We’re looking for the best stream of income. Most income investors have a mix of dividend stocks and bonds—and that mix is highly dependent on interest rates.

When a risk-free government bond pays close to 5%, essentially every dividend stock in your portfolio is competing with it for your money. Those risks apply to us too.

Just look at so-called bond proxy stocks over the past few months. I’m talking about utilities, REITs, telecoms, and consumer staples. These are all favorites of mine. They tend to have solid yields and fairly low risk. But that risk is not zero. When Treasury yields climb toward what these stocks yield, some investors sell and buy the bonds instead.

We’ve seen this in action.

Many of these proxy stocks started sliding in August as the markets anticipated a September rate hike. That’s interest rate risk. If we want to sell our shares of these bond proxies right now, we are staring at a lower price that’s a direct result of higher interest rates.

In reality, some of that effect is being offset by the current rotation out of tech and into boring blue-chips. But it’s still a very real risk.   

Investment Horizon Is Key

Both interest rate risk and reinvestment risk come down to investment horizon. How long do you plan to keep your money invested before cashing out to meet some financial goal or personal obligation?

Interest rate risk occurs when your time horizon is shorter than your bond maturity. Dividend stocks don’t have a maturity, but this is a still a risk if you have to sell during periods when rates are being hiked. As rates go up, prices for high-quality dividend payers will go down, at least temporarily.

Reinvestment risk occurs when your time horizon is longer than your bond maturity. As rates go down, dividend stock prices will rise as investors chase yield. You’ll have to decide if you’re ready to take your capital gains off the table. However, if we’re in a bull market, it’s going to be harder to lock in a comparable yield with comparable risk.

Both are valid risks that we should be considering. I’ve seen it through my career.

I started writing for my first dividend investing newsletter back in 2011. At the time, the US 10-year Treasury yield was just 2.7%. The Fed had interest rates pinned to essentially zero. Reinvestment risk was a daily problem. As investments matured, the current available yields seemed to get lower and lower.

It’s a stark contrast to today, where a 10-year Treasury pays a 4.8% yield and we have to keep an eye on interest rate risk. The CME FedWatch shows an 82% chance of a rate hike in December.  

It’s more important than ever to have an idea of your investing horizon. That’s the first line of defense for both of these risks. Once you have that figured out, then you can start planning how to maximize your income as interest rates move around.

For more income, now and in the future,

Kelly Green