Reinvestment risk

Definition

Reinvestment risk is the possibility that an investor will not be able to reinvest cash flows from an investment at a rate comparable to the original investment's rate of return. This risk is particularly significant for bonds and fixed-income securities when interest rates decline.

5 Must Know Facts For Your Next Test

1. Reinvestment risk is higher for callable bonds because they can be redeemed by the issuer before maturity, often when interest rates drop.
2. Zero-coupon bonds are less affected by reinvestment risk as they do not make periodic interest payments.
3. Interest rate changes directly impact reinvestment risk; falling rates increase this risk as future cash flows may yield lower returns.
4. Reinvestment risk affects both bond coupon payments and principal repayments upon maturity or call.
5. Investors can mitigate reinvestment risk by laddering bond maturities or investing in bonds with different durations.

Review Questions

• Why is reinvestment risk higher for callable bonds compared to non-callable bonds?
• How do zero-coupon bonds help in minimizing reinvestment risk?
• What strategies can investors employ to manage reinvestment risk?

Related terms

Callable Bond: A bond that can be redeemed by the issuer before its maturity date, often leading to increased reinvestment risk.

Zero-Coupon Bond: A bond that does not make periodic interest payments but is issued at a discount, maturing at face value.

Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures, considering both coupon payments and capital gains or losses.