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Let’s Try a Practice Question:
Reinvestment risk is an ongoing concern for investors who own bonds. When asked by a client how to address this risk in her portfolio, an RR might discuss the benefits of?
- Dollar-cost averaging
- Constructing a bond ladder
- Breakpoint sales
The correct answer is 3.
Understanding Bond Ladders
Reinvestment risk is all the cash flow you are getting from a bond that is to be reinvested into whatever interest rate climate or return climate that you can possibly get. With reinvestment rate, it is all about building a ladder, a bond ladder. An example of a bond ladder is, “say you are going to buy a series of 10 bonds, of all these bonds you can choose the different maturities you would like. You can buy 10 bonds that all have five-year maturities.
When you have the same bond maturities, you only have to worry about that time, due to the fact that all the bonds are going to come due in 5 years. One problem is, all bonds are going to come due in the same year, so all the cash you must worry about reinvesting will all be dropped on your doorstep at the exact same time, 5 years out. This means whatever interest rates have done or where they sit today, five years later, you must take all that capital that you are getting 5 years later and reinvest it. You can only reinvest all those bonds at the time, so you are at the mercy of the bond market. These are all the assets you have held for the time being.
A lot of credit analysts will recommend doing a staggering portfolio or in other terms used; a laddered portfolio. An example of this is, if you are buying 10 bonds, buy 1 bond with a 1-year maturity, another bond with a 2-year maturity, another bond with a 3-year maturity, etc. Therefore, each year with a little sequence here, only one-tenth, or one piece of the portfolio is going to mature. So instead of having to redeploy all that capital at one time, you set it up so that you only worry about reinvesting just that one element of the overall portfolio. You stagger these spread-out maturities, then you do not effectively put all eggs into one maturity basket. It really does ease off the reinvestment rate risk issue that you have.
So again, another way to look at not putting all your eggs in the same basket is called the bond ladder. You will sometimes see that explained or described on the Series 7 exam as staggering maturities. The other three choices in this question do not necessarily have anything to do with this example at all, they do not speak to the question of, “Hey, how does that reinvestment rate risk work, and how can a bond ladder be helpful?”