How Does Bond Reinvestment Work?

Solid investments can be a key to financial security.
i Goodshoot/Goodshoot/Getty Images

Young investors interested in adding bonds to a portfolio of investments have a number of options as to what type to include and what to do with the earnings. Reinvesting the earnings on a continual basis can help build a substantial bond portfolio throughout the years as you work to obtain financial security. Re-investing the earnings from your bonds can be accomplished in several ways, including through a mutual fund that owns bonds, by building a bond ladder, or by simply buying new bonds with the income from those you already own. How it works depends on what method you use.

Power of Compounding

Just as with any investment where income and earnings are re-invested, bond re-investment takes advantage of the power of compounding. If accrued interest is consistently re-invested for a number of years, eventually the interest will surpass the principal. Let's look at a simple example of $1,000 invested at 4 percent interest throughout 20 years. By year 20 our original $1,000 has grown to $2,191.12, which is the original $1,000 in principal and $1,191.12 in interest. As you can see, the interest on the interest will exceed the interest on the principal. Although interest earnings on bonds fluctuate, the principle is the same.

Bond Funds

Investing in bonds through a mutual fund is one of the easiest ways to re-invest earnings. Many mutual funds allow investors, once enrolled, to re-invest earnings in partial shares if necessary. For example, suppose the current net asset value of the fund is $9 and you own 1,000 shares in the fund. Your current holdings equal $9,000. Now suppose holdings within the fund earn what amounts to $.07 per share this month. Your portion would earn $70 in income. When re-investing the earnings, the fund allows purchases of partial shares. You could buy 7.77 additional shares at the current net asset value, or NAV, of $9, increasing your overall holdings in the fund to 1,007.77 shares.

Bond Laddering

Another way of re-investing both the income and principal from bonds is through bond laddering. The concept of bond laddering works through purchasing bonds with staggered maturity dates. For example, to build a ladder you can buy bonds with one-, two- and three-year maturities. When the one-year bonds mature, re-invest the principal and interest in three-year bonds. At this time your two-year bonds will lack one year to maturity and your three-year bonds will lack two years to maturity. Continuing in this fashion and re-investing the proceeds each year is a means of re-investing while taking advantage of changing interest rates.

Saving Earnings

Saving coupon earnings and buying a new bond as soon as possible is another way to re-invest income from bonds. However, this method requires self-discipline if you are not investing large amounts initially, as you will have to set the earnings aside until you accumulate enough to purchase more debt securities. However, over time, if you put forth the effort, a substantial bond portfolio can be purchased simply through reinvesting interest earned by purchasing additional bonds.

the nest