Reinvestment Risk
Quick Definition
The risk that cash flows from a bond (coupons or principal) will be reinvested at lower interest rates than the original investment.
Key Takeaways
- Risk of reinvesting cash flows at lower rates when rates decline
- Particularly affects callable bonds and mortgage-backed securities
- Zero-coupon bonds eliminate reinvestment risk entirely
- Works opposite to price risk — falling rates hurt reinvestment but boost prices
What Is Reinvestment Risk?
Reinvestment risk is the possibility that an investor will not be able to reinvest the periodic coupon payments or returned principal at a rate equal to the bond's current yield. This risk is most significant when interest rates decline, forcing investors to put their cash flows to work at lower rates. Reinvestment risk particularly affects callable bonds (which return principal early when rates fall), mortgage-backed securities (due to prepayments), and high-coupon bonds (which generate more cash flow requiring reinvestment). Zero-coupon bonds eliminate reinvestment risk entirely because they make no interim payments — the investor's return is locked in at purchase. Reinvestment risk works in opposition to price risk: falling rates hurt reinvestment but boost bond prices.
Reinvestment Risk Example
- 1An investor earning 6% coupons in 2024 faces reinvestment risk if rates drop to 3% — each coupon payment now earns half as much when reinvested
- 2Zero-coupon bonds eliminate reinvestment risk since there are no interim cash flows to reinvest
Related Terms
Callable Bond
A bond that gives the issuer the right to redeem it before maturity at a specified price, typically when interest rates fall.
Zero-Coupon Bond
A bond that pays no periodic interest, instead sold at a deep discount and redeemed at full face value at maturity.
Mortgage-Backed Security (MBS)
A bond-like investment created by pooling mortgage loans and selling shares of the cash flows to investors.
Yield to Maturity (YTM)
The total annualized return an investor earns if a bond is held until maturity, accounting for coupon payments, purchase price, and par value at redemption.
Bond
A fixed-income debt security where investors loan money to an issuer in exchange for regular interest payments and return of principal at maturity.
Treasury Bond (T-Bond)
A long-term U.S. government debt security with a maturity of 20 or 30 years, paying semiannual coupon interest.
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