Thinking about Reinvestment Risk

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In my professional career, my touchpoints with fixed income so far are admittedly limited.

From when I started in 2016, all the way into 2022, interest rates were low or even negative. Paired with a long-term bull market, most investors had little interest in the asset class and instead opted for additional risk assets. I’m lucky to have avoided the massive drawdowns of what other investors considered “safe” investment grade fixed income when interest rates started going up.

But today, things look different. Most fixed income, despite the prospect of rising rates, still trades at or above 4%. Even more interesting is the inverted yield curve: Given the expectation of short-term interest hikes and medium-term cuts, investors receive the highest yield on bonds with a year or less to maturity. And accordingly, some of the asset managers are cautious and recommend keeping a shorter duration in bond portfolios. After all, the yield is the highest there. Seems simple, right?

We could talk about why expected rate cuts might speak for exposing yourself to higher duration risk. Even if interest rate cuts come later than originally expected, having a longer duration in your fixed income portfolio (or exposure through other assets like unprofitable tech) might mean that rising rates result in an outsized increase in your mark-to-market values.

But that is not what I want to talk about today.

Instead, I want to talk about the topic of reinvestment risk: Picking shorter-duration, higher-yielding assets over a longer-duration, lower-yielding asset, only to realize that proceeds from the first instrument cannot be reinvested at a competitive rate once maturity rolls around. (And that doesn’t even consider the potential impact of an earlier tax impact - as nicely outlined, among some other topics, in this little piece I read yesterday.)

Reinvestment risk should be top of mind for any investor, especially in fixed income. Admittedly I might be affected by the recency bias (if that even counts for me, since I’ve never experienced higher rates than today), but the chance to lock in 4%+ yields for 5, 10 or 20 years seems generous compared to recent years. While somewhat dependent on the client, I always try to advise not to maximize risk at all costs, but to instead look at how to best achieve your required return with the lowest amount of risk. So if you just sold your business and know that you can cover your personal lifestyle expenses by investing a reasonable part of your overall assets into long-term bonds yielding 3-4%, I think that can sometimes be the better choice than a risky investment that might generate 6%, 7%, or even 10% - but could also fail to do so. One shouldn’t forget the mark-to-market risk (we all saw what happened with Silicon Valley Bank), but if you mentally compartmentalize your portfolio anyways (like I like do according to the Aspirational Investor Framework), I find taking mark-to-market risk to be a reasonable trade-off to achieve long-term stability in your private cash flow.

But reinvestment risk doesn’t just affect fixed income, of course - it also affects other asset classes. Take private equity: For GPs, having predictable paths from purchase to value creation to exit have become more important, so holding on to trusted assets for longer, even if later returns might be lower, is appealing. Hence, we’ve seen the rise of so-called Continuation Vehicles, in which GPs take their trophy assets out of their fund at the end of their typical holding period, and transfer it into a new vehicle, where they can hold it for until an eventual exit at a likely higher value instead of having to sell it to one of their competitors. Longer holding periods with (ideally) predictable returns hopefully result in longer management fee streams, and higher carry. And hopefully also higher returns for their investors, of course.

But in my view, no asset class seems to be more affected - in both positive and negative ways - by reinvestment risk than venture capital:

For the founders, outcomes tend to be binary - it’s either going to be a profitable moonshot, or likely to sizzle and fail. Those rare few founders of well-performing founders that are offered a secondary might be inclined to take the over to take some chips off the table, but likewise, if the company continues to do well, it’s unlikely that any reasonable asset that they buy with those secondary proceeds will outperform their own company.

For the VC investors, those secondaries are a double-edged sword. Given the Power Law, only few companies in a VC fund actually generate significant value, yet in days like today, LPs are more starved for liquidity than ever. Selling a stake in a winning company might satisfy the requirements for liquidity, or might even allow them (if still in their investment period) to make some additional bets. But only few companies make it, so there is a good chance that reinvesting will not achieve the same returns as if your winning company continues to compound. (I also wrote about this matter two weeks ago on LinkedIn.)

Lastly, for the LPs - the investors in the VC funds. They face the same risks as the VC funds themselves. But surprisingly, they might be the biggest beneficiaries of reinvestment risk. In that regard, I loved the view shared by (former) family officer Jamie Rhode: If you are a family office, with a truly long-term time horizon (decades or even generations), venture capital is the ideal asset class, offering not only one of the longest ‘natural’ compounding periods, but also incredibly compelling returns if you manage to pick first- and second-quartile manager. There are other asset classes offering similar compounding periods, such as infrastructure or Listerine royalties, but the returns they offer (while also attractive) are somewhat lower - but of course also connected with lower risks.

However, investors shouldn’t be paralyzed by reinvestment risk. If the fundamental risk-reward of an opportunity changes, you shouldn’t hang on to an asset just because you know it well. I personally see myself affected by reinvestment risk in the prospect of a tax bill: Selling a well-performing position usually means realizing a taxable gain, which is painful, so I’d rather hang on for longer (which in the case of one crypto investment, cost me dearly). But perhaps looking at the market value without taking into account the (already embedded) tax bill was a mistake to begin with. Luckily, some structures already adjust for this, such as funds showing their NAV net of accrued management fees or carry.

But in the end, reinvestment risk is a question of personal preference. Investors that currently try to optimize their short-term returns on fixed income might be doing better today, but might fare less well than those who are willing to lock in today’s “lower” long-term rates, which might end up as higher rates once the inverted yield curve normalizes. They might also fare worse if rates continue to stay lower for longer, or maybe even go up.

In the end, it is up to you if you want to play this game - and if you are ready to trade more investing work and (potentially) higher upside for predictability but lower returns long-term returns. We can also be inspired by some of the world’s more famous investors: From the value investors of the world that look to buy and hold assets forever, to shorter-term oriented investors such as special situation hedge funds, as short as the market-making quant hedge funds.

I suppose in the end, it all boils down to personal preference.

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