Reinvestment Risk at the End of Hiking Cycle
Intro
Hello, I’m Javier Lopez, Fixed Income Specialist, and part of the investment committee at Axxets Wealth Management.
For the last 18 months, we witnessed the most aggressive Fed’s hiking cycle in the last 4 decades; with an increase of 525 bps to the Federal Funds Rate divided into only 11 hikes.
Now, the landscape has changed, as we are at, or very close to the end of this cycle. As a result, the market is expecting rate cuts for the next 24 months, although at different paces along the yield curve. For example, expectations aim to a 70-bps cut of the Fed Funds rate by 2Q24, while a 113-bps cut for the 2Y Yld is expected for the same period.
As the forecasted Yield curve is expected to shift downwards, the Reinvestment Risk arises.
What is Reinvestment Risk? BANNER QUE SALGA CON ESTA PREGUNTA
Reinvestment risk is the potential that the investor will be unable to reinvest cash flows at a better or same rate to their current rate of return, creating an opportunity cost. In other words, is the potential that the cash flows received each following period would be less than the previous ones.
Let’s put it like this:
Imagine you are about to invest 1MM for 3 years and you have two options:
- Invest your money for 1y in a zero-coupon bond (bond with no interest payments before maturity). And reinvest it for another year until year 3. Rates for year 1, 2 and 3 are 5%, 4% and 3% respectively.
- Invest in a 3y zero-coupon bond at a fixed rate of 5%.
The opportunity cost, or difference of investing under the 1st option is roughly $33,000 or 3%.
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As we speak, the 1Y expected rates for the next 5y, signal a clear downtrend from 5.38% to 3.63%, around 175-bps difference. BANNER QUE SALGA LA GRÁFICA DE TASAS
How can we mitigate this risk? BANNER QUE SALGA CON ESTA PREGUNTA
We consider that IG is an attractive sector to be exposed to as it will help lock in decade-high ylds that will be even more appealing as interest rates go down during the next 12m. Especially in maturity bands between 5-10 years where the difference of BBB-rated corporate bonds with Treasuries range between 120 and 160 bps.
Final remarks
- With expectations of lower rates, reinvestment risk becomes significant
- But, there are way to mitigate it, for example, IG corporate bonds offer attractive rates in tenors between 5-10y that will help lock-in decade high ylds.