Reinvestment Rate - Explained
What is a Reinvestment Rate?
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Table of ContentsWhat is a Reinvestment Rate?How Does a Reinvestment Rate Work?Reinvestment RiskReinvested Coupon Payments
What is a Reinvestment Rate?
Reinvestment rate refers to the rate at which cash flows from an investment can be reinvested into another. It is also the amount of interest that an investor can earn when the cash flow from one investment is taken out and put into another. Individuals who put money into a fixed-income investment can take money out of it to invest in another tool, the amount of interest earnable on such an investment is known as the reinvestment rate.
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How Does a Reinvestment Rate Work?
Reinvestment rate often occurs when an investor purchases a new bond while he is still holding a callable bond, this is the interest rate that such an investor can earn on the investment. Reinvestment rate is important to investors when making decisions as to what to invest in due to the tendency of interest rate risk in the market. Interest rate risk affects the prices of bonds, interest rate risk occurs when the interest rate of a bond increases after it had been issued. When this occurs, it means the price of the bond will decline, hence, the higher the interest rate, the lower the price of a bond. Using reinvestment rates, investors than decide the position or term to select when purchasing bonds, whether short-term or long term.
There are certain risks that come with reinvestment rate, these are called reinvestment risks. Reinvestment risk is connected with interest rate risk. When there is a decrease in the interest rate, the price of a bond increases and when there is an increase in interest rate, the price of the bond decrease. If an investor holds on to a bond when there is a decrease in interest rate, such investment is exposed to reinvestment risk because there will be a reduction in the amount of interest that can be earned during the reinvestment period.
Reinvested Coupon Payments
In some investments, especially bonds, the coupon payments that an investor should receive are reinvested into the bond thereby earning an additional interest rate. For reinvested coupons, investors are entitled to compound interest rates, since the coupon payments were added back to the bond. There are factors that determine the reinvestment interest rate on these types of investments, these are the holding period and reinvested interest rate.