Loading the player...

What is 'Reinvestment Risk'

Reinvestment risk is the probability that an investor will be unable to reinvest cash flows (e.g., coupon payments) at a rate comparable to the current investment's rate of return. Zero-coupon bonds are the only fixed-income instrument to have no investment risk since they issue no coupon payments.

BREAKING DOWN 'Reinvestment Risk'

Reinvestment risk is the likelihood that an investment's cash flows will earn less in a new security.  For example, an investor buys a 10-year $100,000 Treasury note with an interest rate of 6%. The investor expects to earn $6,000 per year from the security. However, at the end of the term, interest rates are 4%. If the investor buys another 10-year $100,000 Treasury note, he will earn $4,000 annually rather than $6,000. Also, if interest rates subsequently increase and he sells the note before its maturity date, he loses part of the principal.

Callable Bonds and Reinvestment Risk

Callable bonds expose investors to reinvestment risk as the bonds are typically redeemed when interest rates begin to fall.  Upon redeeming the bonds, the investor will receive the face value and the issuer has a new opportunity to borrow at a lower rate. If willing to reinvest, the investor will do so receiving a lower rate of interest.

For example, Company A issues callable bonds with an 8% interest rate. Interest rates subsequently drop to 4%, presenting the company with an opportunity to borrow at a much lower rate.  As a result, the company calls the bonds, pays each investor their share of principal and a small call premium, and issues new callable bonds with a 4% interest rate. Investors may reinvest at the lower rate or seek other securities with higher interest rates.

Reducing Reinvestment Risk

Investors may reduce reinvestment risk by investing in non-callable securities. Also, zero-coupon bonds may be purchased since they do not make regular interest payments. Investing in longer-term securities is also an option since cash becomes available less frequently and does not need to be reinvested often.

A bond ladder, a portfolio of fixed-income securities with varying maturity dates, may help mitigate reinvestment risk.  Bonds maturing when interest rates are low may be offset by bonds maturing when rates are high.

Having a fund manager can help reduce reinvestment risk; therefore, some investors consider allocating money into actively managed bond funds. However, because bond yields fluctuate with the market, reinvestment risk still exists.

  1. American Callable Bond

    An American Callable Bond can be redeemed by the issuer at any ...
  2. Conditional Call Option

    A conditional call option requires a bond's issuer to replace ...
  3. Bond Ladder

    A bond ladder is a portfolio of fixed-income securities in which ...
  4. Noncallable

    A noncallable security is a financial security that cannot be ...
  5. Rate Level Risk

    Rate level risk refers to the fact that the value of an existing ...
  6. Fixed Income

    Fixed income is a type of investment in which real return rates ...
Related Articles
  1. Investing

    Six biggest bond risks

    Bonds can be a great tool to generate income, but investors need to be aware of the pitfalls and risks of holding corporate and/or government securities.
  2. Investing

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  3. Investing

    Callable Bonds: Leading a Double Life

    Learn the difference between a normal bond and a callable bond. Discover five things you must know before investing and why callable bond lives a double-life that contains so much risks.
  4. Investing

    5 Best Ways to Earn Interest

    Learn how to use tools to increase your interest earnings. Use compounding interest and breakpoints to increase your interest income.
  5. Investing

    The Risks Associated with Common Investments

    Investing inherently involves some risk. Here are some of the different types of investment risks.
  6. Investing

    Here's What Happens When a Bond Is Called

    Learn why early redemption occurs and how to avoid potential losses.
  7. Retirement

    Should retirees reinvest their dividends?

    Find out why dividend reinvestment may or may not be the right choice for retirees, depending on their financial needs in retirement and investment goals.
  8. Investing

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  9. Investing

    How Dividend Reinvestment Grows Your Money Faster

    Dividend reinvestment is a smart strategy for growing your investments faster over the long term, but it’s not a get-rich-quick proposition.
  1. What are the risks of investing in a bond?

    Are you thinking of investing in bond market? Learn more about bond market investment risk, including interest rate risk, ... Read Answer >>
  2. Under what circumstances might an issuer redeem a callable bond?

    Understand why an interest rate drop usually compels bond issuers to redeem callable bonds and re-issue them at the new, ... Read Answer >>
Trading Center