Risk that incoming cash flows must be reinvested at a rate below the one assumed in the return projection, the mirror image of price risk and dominant when liabilities outlast assets.
A bondholder faces two opposite rate risks. If rates rise, the market value of the securities falls: that is price risk. If rates fall, the coupons and redemptions received are reinvested less well: that is reinvestment risk. Duration immunization consists precisely in balancing the two so their effects cancel. Reinvestment risk becomes dominant as soon as liabilities are longer than assets, the usual configuration of annuities and guaranteed rate contracts: every euro coming in must be reinvested for a residual term the market does not always allow you to cover. It is all the more dangerous for being silent, since it shows up in no unrealized loss and manifests only as a gradual erosion of portfolio yield. The European life sector suffered it through the decade of low rates, as maturing high coupon bonds were replaced by securities yielding close to zero, while the guarantees owed to policyholders stayed fixed by contract.
Bond portfolio of a life insurer as of December 31, 2021. Average book yield 2.4%, reinvestment yield for the year 0.4%, average rate guaranteed to policyholders 1.1%. With 7% of the portfolio maturing each year, the two-point gap on the reinvested share eroded portfolio yield by roughly fourteen basis points a year, mechanically, with no management decision involved.
reinvestment risk, risque de replacement, risque de taux futur, risque sur flux entrants