When we sell a security, we are doing so with the understanding that we can re-invest the proceeds in a way that will maintain our nominal returns. The logic behind this is fairly simple, in that we wouldn’t sell the security if we didn’t feel as though there was a long-term benefit for us to do so.
However, there are many times in which we might sell a security for short-term gains, only to later realize that we should have maintained our position for the sake of hanging on to a good thing, even if we did get a good short-term profit from the sale. This evaluation is known as the analysis of Re-Investment risk, and it becomes a major part of our buy-or-hold decision framework when dealing with fixed-income investments.
The re-investment decision comes down to an evaluation of nominal returns. I’ll illustrate by example to make this easier. Suppose you earn $50/month from a bond portfolio that you paid $1000 for in total. One day, you wake up to find that the market is willing to pay you $1100 for that portfolio. However, because of the appreciation in the value of bonds, the only new-offering you will be able to invest your $1100 into will be at $10/month. Do you buy or hold in this situation? Given that the re-investment rate is so extremely low, you will not likely re-invest, because you could earn way more money by simply holding onto the investment than by taking the $100 extra money and –reinvesting.
What if that re-investment return was suddenly $35/month? Suddenly, we can see that there is an incentive to sell, because the $100 profit from the sale would be equivalent to about 4-5months of the difference between the payment rates. The end result is that we might be inclined to sell because will earn a decent short and medium term return.
The easiest way to then understand how this works is to look at what happens if we could re-invest at the same rate as we held before. If we sold the portfolio for $1100, and could re-invest it for $50/month, we would do so again because we would be walking away with a $100 profit right away. If we could do so instead for $60/month, we’d also pursue the opportunity, because we are making even more money from the greater rate of return.
However, once we start seeing the payments decrease, even in light of a big cash payout from capital gains, we need to be asking ourselves about our real objectives behind the transaction. Is the extra $100 now really worth it, if we’re going to be decreasing the regular amount of money that we receive for bills every month? What about future trends, could we make more money by simply hanging onto the security for a little bit longer? Being an extremely subjective process, Re-Investment risk is one of the reasons why investment advisors will be hard-pressed to sell into a rising bond market.
