Reinvestment Risk

Reinvestment risk is especially important for bond investors and savers. When interest rates fall, the coupons they receive and the principal returned at maturity must be reinvested at the new, lower rates.

For example, an investor holds a five-year bond paying 5% a year. When it matures, interest rates have fallen to 2%. The investor can now only reinvest the money at 2%, reducing their future income significantly.

Reinvestment risk also affects callable bonds. Issuers tend to repay callable bonds early when interest rates fall, forcing investors to reinvest at lower rates just when they would prefer to keep their higher-yielding bonds.

Reinvestment risk works in the opposite direction from interest rate risk. When rates rise, bond prices fall, but reinvested cash earns more. When rates fall, bond prices rise, but reinvested cash earns less.

Investors can reduce reinvestment risk by buying longer-term bonds, zero-coupon bonds that pay no interest until maturity, or by spreading investments across bonds with different maturities, a strategy known as laddering.