Do TIPS have reinvestment risk, and if so, how does it differ from nominal bonds?

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AcadiFi · Accepted Answer

**Yes, TIPS have reinvestment risk** — the risk that coupon cash flows will be reinvested at lower yields than the bond's original yield. The nature differs from nominal bonds.

**Nominal bond reinvestment risk:** Reinvesting coupons at changing nominal rates. Total realized yield depends on future nominal rate path.

**TIPS reinvestment risk:** Reinvesting coupons at changing real yields. Since coupons are paid on inflation-adjusted principal, the nominal coupon amount changes, but the real amount is fixed as a percentage of real principal.

**Key distinction:** TIPS isolate reinvestment risk to the REAL component. An investor reinvesting a TIPS coupon faces risk that future real yields fall, not future nominal yields.

**Example — Thornbury Insurance holds 10-year TIPS:**
- Real coupon: 1.50%, $10M original face, CPI = 310 at issue
- Year 1 CPI = 316.2 (2% inflation)
- Indexed principal = $10M × (316.2/310) = $10.2M
- Coupon = 0.75% × $10.2M = $76,500
- Thornbury reinvests this $76,500. If real yields available for reinvestment have dropped from 1.50% to 0.80%, they lock in a lower real return on the reinvested cash flows

**Why TIPS still have reinvestment risk:**
- Total realized real return = f(real yield at purchase, reinvestment real yield path)
- Only a zero-coupon TIPS (STRIPS-style) fully eliminates reinvestment risk
- Standard coupon TIPS pay semi-annual coupons that must be reinvested

**What TIPS ELIMINATE:**
- Inflation risk on principal (indexed directly)
- Inflation risk on coupons (real coupon paid on indexed principal)

**What TIPS DON'T ELIMINATE:**
- Real rate risk on reinvested coupons
- Price risk before maturity (real yields moving change TIPS prices just like nominal yields change nominal bond prices)
- Liquidity risk

**Practical mitigation:** Matching cash flows to liabilities (cash flow dedication) or using zero-coupon TIPS reduces reinvestment risk. Long-dated TIPS have higher reinvestment risk due to more coupons.

Do TIPS have reinvestment risk, and if so, how does it differ from nominal bonds?

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