What is reinvestment risk and how can I protect my portfolio?

The European Central Bank’s (ECB) move to lower interest rates by 25 basis points to 4.25% came as no surprise to investors, given recent remarks by ECB President Christine Lagarde and other central bankers. After years of not being a profitable option for savers, the ECB's aggressive rate hikes since 2022 have revived interest in fixed income investments. Although rate cuts are typically well-received by the market, analysts caution that this reduction brings reinvestment risk, a significant concern for fixed income investors.

“This risk arises for fixed income investors due to a decline in interest rates. It’s particularly relevant when an investor who has purchased short-term fixed income instruments, such as Treasury bills or bonds, is faced with the maturity of such issues,” explains Ignacio Amo, fund selector at MAPFRE Gestión Patrimonial.

Amo highlights that if interest rates have fallen since the bill or bond was purchased, investors seeking to reinvest in a similar instrument will encounter a less appealing return. “Once a period of rate cuts is confirmed in Europe, we could see a process of yield curve steepening that would favor higher IRRs or higher yields on longer maturities. This would make it somewhat less attractive in the shorter tranches, where the instruments most affected by reinvestment risk are located,” he adds.

This means that when the bill in the portfolio reaches maturity, the investor might find the return less attractive compared to investments with a longer duration. Thus, having the portfolio solely positioned in a single bill or a bond can negatively impact the investor.

What can we do to avoid reinvestment risk?

The primary way to mitigate reinvestment risk is through diversification, both in the types of fixed income instruments within the portfolio and in the maturities of these instruments. “The best instrument for achieving effective diversification is a mutual fund, where specialized professionals can offer the opportunity to invest in a portfolio of bonds and bills, thereby mitigating reinvestment risk,” notes the fund selector.

For Amo, it’s important to understand that we’re emerging from a period of low (or even negative) rates, and it’s expected that rates will remain positive in the medium term, without reverting to the low levels of the past. This new scenario marks a paradigm shift, where fixed-income managers will have some material to work with.

“From our perspective, it’s still quite difficult to determine the most appropriate moment to add duration to portfolios. This is why we think delegating a good portion of the fixed-income portfolio components to active and flexible managers may be most suitable. They can use positions in a variety of assets to achieve an IRR/Term/Risk triangle for debt instruments that’s higher than what could be achieved by selecting a specific asset type, such as having exposure only to a bill or a bond,” states Amo.

And even if the shorter tranches are less attractive, MAPFRE Gestión Patrimonial believes that it still makes sense to be positioned in these tranches, since the famous accrual "still makes sense." “We can continue to take advantage of this opportunity with money market or short-term fixed income funds, where diversification, flexibility, and managers’ skills allow us to capitalize on this opportunity,” concludes Amo.