Reinvestment risk
Also written Re-investment risk
The risk that the coupons or other intermediate cash flows from an investment have to be put back to work at a lower rate than the original investment earned, pulling the total return below the promised yield.
In plain language
A bond paying 9% does not actually deliver 9% unless every coupon it throws off can be reinvested at 9% too. If rates have fallen by the time the money arrives, the coupon goes back to work at 6%, and the total return over the life of the holding is less than the yield printed on the contract.
That gap is reinvestment risk. It is unusual among risks in that it hurts when things appear to be going well — a falling rate environment lifts bond prices and simultaneously wrecks the reinvestment assumption.
How it works
The workbook states the direction in two lines:
- If interest rates rise, reinvestment risk reduces or is eliminated.
- If interest rates fall, reinvestment risk increases.
It sits in direct opposition to price risk. Rates rise, the bond's price falls but the coupons reinvest better; rates fall, the price rises but the coupons reinvest worse. That opposition is the entire reason duration matching exists.
The workbook's remedy is to choose the cumulative option available in most debt investments, so the issuer compounds the income internally and there is no intermediate cash flow to reinvest — with the warning that in a marketable security this exposes the holder to higher price volatility, because all the money now arrives at the end.
Chapter 12 classifies reinvestment risk as a systematic risk, alongside market, inflation, exchange rate and interest rate risk — it cannot be diversified away, because the rate that hurts one bond's coupons hurts everyone's.
The formula
Terminal value of a reinvested coupon stream
= Coupon × [ (1 + r)^n − 1 ] ÷ r
where r is the actual rate at which coupons are reinvested — not the coupon rate, and not the YTM.
A worked example
An investor puts Rs 1 crore into a 5-year bond paying a 9% annual coupon, so Rs 9 lakh arrives each year.
If rates hold at 9%, the coupon stream compounds to
9 × [ (1.09^5 − 1) ÷ 0.09 ] = 9 × 5.9847 = Rs 53.86 lakh
Total at the end of five years: Rs 153.86 lakh.
If rates fall to 6% shortly after purchase, the same coupons compound to
9 × [ (1.06^5 − 1) ÷ 0.06 ] = 9 × 5.6371 = Rs 50.73 lakh
Total: Rs 150.73 lakh. The shortfall is Rs 3.13 lakh, and nothing went wrong — the issuer paid every rupee it promised, on time.
The investor still reports a 9% coupon. The realised return on the Rs 1 crore is not 9%; it is what turns Rs 100 lakh into Rs 150.73 lakh over five years, about 8.56% a year. The missing 44 basis points is reinvestment risk, and it was collected by falling interest rates, not by any default.
Why NISM asks about it
Chapter 12 (Fundamentals of Risk and Return) defines reinvestment risk in the list of risks an investor faces, immediately after call risk, and then classifies it as systematic in the systematic-versus-unsystematic section. Expect the two directional statements as a direct question — rates up means risk down, rates down means risk up — and the pairing with call risk.
Common exam traps
- Rising rates reduce reinvestment risk. Candidates reverse this because rising rates are bad for bond prices. Price risk and reinvestment risk move in opposite directions.
- The workbook classes reinvestment risk as systematic, not unsystematic. It is not diversifiable — it belongs with market, inflation, exchange rate and interest rate risk.
- It has nothing to do with the issuer's creditworthiness. A government bond has full reinvestment risk and no credit risk.
- Call risk makes it worse, not separate. An issuer calls a high-coupon bond exactly when rates have fallen, forcing the whole principal to be reinvested at the new lower rate.
- A zero-coupon or cumulative structure removes it — there are no intermediate cash flows — but the workbook notes this raises price volatility in a marketable security.
- YTM quietly assumes every coupon is reinvested at the YTM itself. That assumption is what reinvestment risk breaks.
Where this is taught
- Series XV · Chapter 12: Fundamentals of Risk and Returnintroduced here
- Series X-A · Chapter 9: Investing in Fixed Income Securitiesintroduced here
- Series V-D · Chapter 18: Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Marketsintroduced here
- Series IV · Chapter 1: Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Marketsintroduced here
Related terms
- Interest rate riskThe risk that an investor in a debt instrument loses return because rates rise — existing instruments carrying the old, lower coupon fall in value until their yield matches the new market rate.
- Modified DurationMacaulay's duration divided by (1 + yield) — the percentage by which a bond's price moves for a one percentage point change in interest rates, and so the standard measure of interest rate risk.
- Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
- Yield to MaturityThe single discount rate at which a bond's future coupons and redemption amount add up to exactly its market price today — the return you actually earn if you hold it to maturity.
- Risk-free rateThe rate on a sovereign borrowing in its own currency, where credit risk is absent because the government can print the money — the benchmark every other valuation is measured against.
- Holding period returnThe total of coupons, income earned on reinvesting them and any capital gain, expressed as a percentage of the purchase price — a crude return for the period actually held, with no compounding in it.