Reinvestment risk

Reinvestment risk is the risk that cash flows from an investment, such as bond coupons or principal returned at maturity, have to be reinvested at a lower interest rate than the original investment was earning. It is effectively the mirror image of interest rate risk: rising rates hurt a bond's current market price but help future reinvestment, while falling rates help a bond's current market price but hurt future reinvestment.

The risk is highest for bonds with shorter maturities and for bonds that return cash to the investor more frequently, since there is more principal and interest coming due that needs a new home sooner. A callable bond carries particularly acute reinvestment risk, since issuers tend to exercise call risk and redeem bonds early precisely when interest rates have fallen, forcing the investor to reinvest the proceeds right when rates are least attractive.

Investors manage reinvestment risk in several ways, including building a bond ladder, which staggers maturities so that only a portion of the portfolio needs reinvesting at any given time, and using bond duration matching to align a portfolio's overall interest rate exposure with a specific future need. Zero-coupon bonds carry no reinvestment risk before maturity, since they make no periodic payments to reinvest in the first place, though the return an investor locks in only holds if the bond is held to maturity.