Quick Answer
Reinvestment risk is the risk that cash flows like coupon payments must be reinvested at lower interest rates, most relevant when rates fall. Callable bonds, mortgage-backed securities, and high-coupon bonds carry high reinvestment risk. Zero-coupon bonds have zero reinvestment risk but maximum interest rate risk, since interest rate risk and reinvestment risk move in opposite directions.
Interest rate risk and reinvestment risk are two sides of the same coin. Understanding how they work in opposite directions is a key SIE concept.
What Is Reinvestment Risk?
- Reinvestment risk is the risk that cash flows from an investment (coupon payments, principal repayments) will need to be reinvested at lower interest rates
- Most relevant when interest rates are falling
- You receive your scheduled payment on time, but you cannot reinvest it at the same attractive rate you originally locked in
Which Investments Have High Reinvestment Risk?
- Callable bonds - the issuer calls the bond when rates drop, forcing the investor to reinvest returned principal at lower rates
- Mortgage-backed securities (MBS) - homeowners refinance at lower rates, returning principal to MBS investors earlier than expected
- High-coupon bonds - more cash flow to reinvest means more exposure to reinvestment risk
Zero-Coupon Bonds: Zero Reinvestment Risk
- Zero-coupon bonds have no reinvestment risk because there are no periodic cash flows to reinvest
- The investor's return is locked in at purchase (the discount from par)
- This is the opposite of their interest rate risk profile (maximum interest rate risk, zero reinvestment risk)
Exam Tip: Gotchas
- Zero-coupon bonds have ZERO reinvestment risk but maximum interest rate risk. This contrast is frequently tested.
- Any bond that pays periodic coupons has some reinvestment risk. No coupons = nothing to reinvest.
Interest Rate Risk vs. Reinvestment Risk
These two risks work in opposite directions:
| Scenario | Interest Rate Risk | Reinvestment Risk |
|---|---|---|
| Rates rise | Bond prices fall (bad) | Cash flows reinvested at higher rates (good) |
| Rates fall | Bond prices rise (good) | Cash flows reinvested at lower rates (bad) |
| Risk Type | Triggered When | Worst For |
|---|---|---|
| Interest rate risk | Rates rise | Long-term, low-coupon bonds |
| Reinvestment risk | Rates fall | High-coupon bonds, callable bonds, MBS |
Exam Tip: Gotchas
- Interest rate risk and reinvestment risk move in opposite directions. Rising rates hurt bond prices but benefit reinvestment. Falling rates help bond prices but hurt reinvestment.
- Callable bonds have the highest reinvestment risk. The issuer calls when rates drop, forcing you to reinvest at lower rates.
Reinvestment risk is especially acute for mortgage-backed securities (MBS), where borrower behavior creates a unique form of this risk called prepayment risk.
What Should You Check on Exam Day?
- Can you explain why falling interest rates increase reinvestment risk?
- Do you know why zero-coupon bonds have zero reinvestment risk?
- Can you explain why zero-coupon bonds still carry maximum interest rate risk?
- Do you know why callable bonds carry the highest reinvestment risk?
- Can you explain how interest rate risk and reinvestment risk move in opposite directions?