Reinvestment Risk
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.