Reinvestment risk
Reinvestment risk is the risk that cash flows from an investment — bond coupons, maturing principal, or called bonds — will have to be reinvested at a lower interest rate than the original investment earned.
Reinvestment risk is the danger that money coming back to you from an investment cannot be put back to work at the same rate of return. It primarily affects bond investors, who regularly receive interest payments and eventually get their principal back. If market interest rates have fallen in the meantime, those dollars must be reinvested at the new, lower rates.
Consider an investor holding a bond with a 6% coupon. If prevailing rates drop to 4%, every coupon payment received now earns only 4% when reinvested, and when the bond matures, the entire principal faces the same problem. Callable bonds make this worse: issuers call bonds precisely when rates have fallen, handing investors their money back at the worst possible time to reinvest it.
Reinvestment risk moves opposite to interest rate risk. Falling rates hurt reinvestment but lift bond prices; rising rates hurt prices but improve reinvestment opportunities. Zero-coupon bonds, such as Treasury STRIPS, eliminate reinvestment risk on interest because they make no coupon payments — the return is locked in at purchase if held to maturity. That is a heavily tested point.
The SIE, Series 7, and Series 65 exams all test reinvestment risk in their debt securities and suitability material. Expect questions asking which bonds carry the most reinvestment risk (high-coupon, callable bonds when rates are falling) and which carry the least (zero-coupon bonds held to maturity).
Key takeaways
- Reinvestment risk is the chance that coupons and principal must be reinvested at lower rates than the original investment earned.
- Falling interest rates create reinvestment risk; callable bonds amplify it because they are called when rates drop.
- Zero-coupon bonds like Treasury STRIPS avoid coupon reinvestment risk entirely when held to maturity.
- Reinvestment risk and interest rate (price) risk move in opposite directions.