Reinvestment Risk

I’m continuing to explore a few ideas in greater depth, mostly in the energy sector, but haven’t reached conviction on any one idea in particular.  Great opportunities are generally very hard to come by.  There are greater than 50,000 publicly traded companies worldwide.  Most people can probably follow only 30-50 companies while maintaining a high standard of quality.  Therefore, it’s critical to (i) focus on your areas of competence and slowly expand the circle over time, (ii) develop strong filters so ideas can be quickly weeded out, and (iii) bet large sums of money when a superior opportunity is identified.

As mentioned previously, I’ll continue to write on topics which I’m thinking about.  One common perception which I’ve been pondering is that rising interest rates will harm bond portfolios.  The consensus opinion is that interest rates will rise, perhaps dramatically, over the coming years.  It’s interesting to note that this has been the consensus view over the past four years, a time period when interest rates have fallen substantially.  It follows that rising interest rates will harm most assets, particularly bonds.

When thinking of a long term bond, say a 30 year bond, a majority of return does not come from coupon payments.  It comes from reinvestment of the coupons (the interest on the interest).  Therefore, in a low rate environment, a 10% coupon bond will generate a lower yield to maturity than the 10% stated rate since the coupons will likely be reinvested at a rate lower than 10%.  Stated another way, when a bond is purchased at a stated yield to maturity, the implied reinvestment rate in the calculation is the quoted yield to maturity.  However, it doesn’t have to be.  In an environment where treasuries are 3%, it’s not reasonable to assume that all coupons can be reinvested at a 10% rate.  For this reason, the yield to maturity calculation is somewhat illusory.

Most bond investors and insurance company portfolio managers are terrified of rising rates.  Yes, when rates rise, quoted bond prices will fall.  However, if a long term bond is held to maturity, the overall return on the bond will increase in a rising rate environment.


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