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.
Check yourself
1.What happens to reinvestment risk when interest rates rise?
- a)It increases sharply
- b)It reduces or is eliminated
- c)It is unaffected by interest rate movements
- d)It becomes a systematic risk only at that point
Show the answer
Answer: (b) It reduces or is eliminated
The workbook states the rule in two lines: "If Interest rate rises, reinvestment risk reduces or is eliminated. If Interest rate falls, reinvestment risk increases."
The mechanism is simple once you see it. Reinvestment risk is the risk that the coupons you receive have to go back to work at a lower rate than the bond itself pays. If market rates have gone up, that worry disappears — you reinvest at a better rate than before.
Option A is the answer most candidates give, because "rates rising" feels like bad news for bond investors generally. It is bad news for bond prices, which is interest rate risk — a different thing. Option C is wrong because the risk is defined entirely by rate levels. Option D confuses classification with magnitude: reinvestment risk is on the systematic list at all times.
2.Which of the following is classified by the workbook as an UNSYSTEMATIC risk?
- a)Interest rate risk
- b)Reinvestment risk
- c)Credit risk
- d)Inflation risk
Show the answer
Answer: (c) Credit risk
The workbook gives two explicit lists. Systematic (undiversifiable): market risk, inflation risk, exchange rate risk, interest rate risk and reinvestment risk. Unsystematic (diversifiable): credit risk, business risk and liquidity risks.
Credit risk is unsystematic because an investor can reduce it by changing what she holds — the workbook's Ashima "can reduce credit risk by increasing the proportion of highly-rated bonds in her portfolio".
Interest rate risk, reinvestment risk and inflation risk are all on the systematic list. Interest rate risk is the one to be most careful with: if rates rise, the price of every bond Ashima holds falls, so no amount of rearranging within bonds helps.
3.Which statement about market risk is correct as per the workbook?
- a)Deposits and small savings schemes have no market risk, but they also do not gain in value due to market factors
- b)Market risk affects all investments equally, including bank deposits
- c)Market risk arises only in equity shares, not in bonds or gold
- d)Market risk can be eliminated by holding a diversified portfolio of equities
Show the answer
Answer: (a) Deposits and small savings schemes have no market risk, but they also do not gain in value due to market factors
The workbook: "Market risk affects those investments which have an active secondary market, and the transactions happen at current applicable prices, such as equity, bonds, gold, real estate, among others. Investments such as deposits or small savings schemes are not marketable securities, and the investor gets a pre-defined amount on maturity. They have no market risk; but they also do not gain in value (or appreciate), due to market factors."
Market risk is "the risk of the loss of value in an investment because of adverse price movements in an asset in the market". The workbook's examples are a rate rise pushing bond prices down, and a rupee appreciation cutting the earnings expectations of exporters.
Why the others are wrong:
- Option B contradicts the carve-out above. Non-marketable deposits carry no market risk.
- Option C is too narrow. The workbook lists equity, bonds, gold, real estate as exposed.
- Option D contradicts the classification. "Market risk, Inflation risk, exchange rate risk, interest rate risk and reinvestment risk are systematic risks", and systematic risks "cannot be eliminated through diversification."
Where this is taught
- Series XV · Chapter 12: Fundamentals of Risk and Returnintroduced here
- Series XXI-B · Chapter 4: Investing in Fixed Income Securitiesintroduced here
- Series X-A · Chapter 9: Investing in Fixed Income Securitiesintroduced here
- Series IV · Chapter 1: Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Marketsintroduced here
- Series V-D · Chapter 18: Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Marketsintroduced here
- Series XXI-A · Chapter 4: Investing in Fixed Income Securitiesintroduced here
- Series XXI-B · Chapter 19: Fixed Income Portfolio Management Strategies
Related terms
- Call riskThe risk that a bond is called — redeemed by the issuer before maturity. Most prevalent when interest rates fall, and it usually goes hand in hand with reinvestment risk.
- 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.
- Pull to parThe movement of a bond's price toward its face value as maturity approaches — premium bonds drift down to par, discount bonds drift up to par, and at maturity every bond is worth face value.
- Coupon effectThe fact that two bonds with the same issuer and maturity but different coupons show different yields to maturity even when both are priced correctly off the same zero curve — why YTM cannot judge mispricing.
- Zero coupon bondA bond that pays no coupons: it is issued below face value and repays the face value at maturity, so its duration equals its maturity.
- Yield to CallThe annualised return on a callable bond if the issuer redeems it at the first call date for the call price — YTM with the call price and call date substituted.
- ImmunizationStructuring a bond portfolio so its value at a target date is protected from interest-rate changes — by matching the portfolio's duration to the liability's timing.
- Barbell strategyA bond portfolio concentrated at the short and long ends of duration with little in the middle, used when rates could move sharply in either direction.
- Buy and Hold strategyA passive strategy of buying securities, or setting an asset mix, and then holding without trading — in equities for the long run, in bonds to maturity, and in rebalancing as "do nothing".
- 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.
- Deep Discount BondA zero-coupon bond of very long tenure, issued at a steep discount to its face value and redeemed at par. IDBI issued such bonds; the Kisan Vikas Patra is another example.
- STRIPSZero coupon bonds created by breaking a Government Security into its individual cash flows, so each coupon and the principal repayment trade separately as independent securities.
- Senior Citizens Saving SchemeA five-year, government-guaranteed deposit for those aged 60 or above, capped at Rs 30 lakh across accounts, paying interest every quarter at a rate the government announces quarterly.
- Post Office Monthly Income SchemeA five-year, government-guaranteed post office deposit paying interest every month, with a Rs 1,500 minimum, a Rs 9 lakh single or Rs 15 lakh joint maximum, and no tax benefits.
- Fixed income securityA debt instrument under which the issuer promises a fixed coupon at regular intervals and repayment of the face value at maturity — government bonds, corporate bonds, debentures and T-bills.
- Inverted yield curveA yield curve on which short-term interest rates are higher than long-term rates — the reverse of the normal upward slope, read as a signal that the economy may go into recession.
- Callable bondA bond that the issuer may redeem before its original maturity date — typically exercised when interest rates fall, leaving the investor to reinvest at lower rates.
- Puttable bondA bond that gives the investor the right to seek redemption from the issuer before maturity — useful when interest rates have risen and better-paying bonds are available.