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One of the risks that investors in debt instrumentsface is reinvestment risk, as a result of fluctuating interest rates in the debt markets. When coupon interest on a bond held is received periodically or when the principal amount is received on maturity, the money has to be reinvested at the interest rate prevailing in the market at that time. The rate may be higher or lower or the same level as the interest rate on the original bond. If the interest rate is lower than that of the original bond, then the coupon interest and principal amount received are reinvested at the lower rate. This risk is known as reinvestment risk in bond investments.

How does reinvestment risk actually impact your finances? When the proceeds are reinvested at a lower rate, the yield-to-maturity (YTM) earned on the investment gets affected. When YTM on a bond is calculated at the time of making the investment, it is assumed that all the income received periodically on the investment held till maturity will be reinvested at the same rate as that paid by the original bond.

However, if the coupons are reinvested at lower rates, then the yield comes down. Let us say you are using a portfolio of bonds to save for a goal and you use YTM of the bonds to decide the amount and period for which you have to invest to reach your goal. If YTM turns out to be lower than what you expected because of the reinvestment being at lower rates, then the accumulated corpus will be lower and you are likely to miss your goal. Similarly, if you are looking to earn a regular income from the coupon interest received on the bonds, and if the bonds are reinvested at lower rates, then the income you earn will come down.

Buying zero-coupon bonds or deep discount bonds, where you buy the bond at a discount to its face value and receive the face value on maturity, is one way to avoid reinvestment risk as here there is no periodic interest payment to invest. Another way is to tie into a higher yield by investing in long-term bonds when you expect lower interest rates in the future.

Reinvestment risk can also be managed by choosing the cumulative option in bonds and deposits where the periodic interest income is reinvested in the same bond or deposit and earns the same rate of interest as the original investment. On maturity of the investment, the principal and the accumulated interest is paid to the investor.

For instance, you invest ₹1 lakh each in bonds maturing in one year, two years, three years, four years and so on. In effect, you have tied in to the interest rate prevalent in the market now and know with certainty the income you will receive for the next few years depending upon the number of steps (years) you have created.

Each year, one set of bonds will mature and you have the money you need to use for your needs or to invest in a new step at the top of the ladder. If the interest rate has gone up, then you invest at the higher rate. If the interest rate is lower, you invest at this lower rate, but since this will be only a small portion of your investment, the impact on the total return will be lower.