Reinvestment risk is the risk that cash returned by an investment cannot be put back to work at the rate the original investment was earning, so the holder keeps the money and loses the yield. It is the risk that no available investments will be able to provide a similar return to a bond that has been called or mandatorily refunded (FINRA, Bonds).
Nothing about it requires a loss on the instrument itself. A holder can be paid in full, on time, at face value, and still be worse off than if the money had stayed where it was.
The Three Ways the Cash Comes Back Early
Reinvestment risk needs cash in hand before the holder’s horizon, and there are only three routes to that.
A coupon arrives. Every interest payment on a bond is money that has to find a new home for the remaining term, and at a lower prevailing rate it earns less than the bond it came from.
The issuer calls the bond. This is the sharpest version, because the issuer chooses the moment and chooses it against the holder. An issuer may call a bond when current interest rates drop below the interest rate on the bond, saving money by paying the bond off and issuing another at a lower rate, and callable bonds are more risky for investors than non-callable bonds because an investor whose bond has been called is often faced with reinvesting the money at a lower, less attractive rate (SEC, Investor.gov, Callable or Redeemable Bonds). What the issuer actually pays at that moment is worked through in face amount of a bond, and what the redemption does to the books is in redemption of bond.
The bond matures. At maturity the principal comes back whether the holder wants it or not, so a portfolio built to a horizon longer than its holdings carries the risk at every maturity date.
The Call Has Three Shapes, and Only One Is the Issuer’s Choice
The redemption feature is not always an option the issuer exercises for profit (SEC, Investor.gov, Callable or Redeemable Bonds).
Optional redemption allows the issuer, at its option, to redeem the bonds, and many municipal bonds carry optional call features exercisable after a set number of years. Sinking fund redemption requires the issuer to redeem a fixed portion or all of the bonds on a fixed schedule, so the cash comes back on a calendar rather than on a rate move. Extraordinary redemption allows a call before maturity if specified events occur, such as damage or destruction of the project the bond financed.
Only the first is timed against the holder. The other two still hand back cash that has to be reinvested, which is why a sinking fund provision carries the same exposure under a different name, one the regulator calls refunding risk and which also leads to reinvestment risk (FINRA, Bonds).
It Pulls Against Price Risk, Which Is Why Neither Can Be Removed
Interest rate risk, also called market risk, is the risk that changes in interest rates may reduce, or increase, the market value of a bond a holder owns, and it increases the longer the bond is held (FINRA, Bonds).
Put the two definitions side by side and they point opposite ways on the same rate move. Falling rates lift the market value of a bond already held and lower the return on everything the holder buys next. Rising rates do the reverse, cutting the market value of what is held and improving what the coupons and the maturing principal can buy.
That is why lengthening or shortening maturities does not make risk go away, it trades one exposure for the other. A long bond concentrates price exposure and defers the reinvestment question; a short one does the opposite. The stated rate a holder is trying to protect, and where it parts company from the market rate, is worked through in coupon rate.
On the Lender’s Side It Arrives as Prepayment
A firm’s lending clients meet the same risk under a different word, and the accounting rules have a considered position on it.
The default position in the standards is that a lender does not get to assume its loans will come back early: the calculation of the constant effective yield uses the payment terms required by the loan contract, and prepayments of principal are not anticipated to shorten the loan term (FASB Statement No. 91, paragraph 19). The narrow exception that lets a lender build prepayment estimates into that yield, and the recalculation and disclosure it drags along, are set out in effective rate method.
Read the default as a statement about reinvestment risk and it says something useful. Assuming the cash comes back early would pull unearned fee income forward into the current period, so the rule makes a lender wait for the event rather than forecast it.
What Reinvestment Risk Is Not
It is not credit risk. Credit risk is the risk that a bond issuer will fail to make interest payments or to pay back principal at maturity (FINRA, Bonds), which is a risk of not being paid rather than a risk of being paid at the wrong time; it is worked through in default risk.
It is not inflation risk either. Inflation risk is the risk that the yield on a bond will not keep pace with purchasing power (FINRA, Bonds), which bites even on a bond that is never called and never matures early.
Common Questions
One is about the price of what you hold and the other is about the return on what you buy next. Interest rate risk changes the market value of the bond in the portfolio (FINRA, Bonds). Reinvestment risk changes what the cash thrown off by that bond can earn. A single move in rates triggers both, in opposite directions, which is why a holder who is protected against one is exposed to the other.
The ones that return no cash before the holder needs it. Reinvestment risk exists only where money comes back early, so an instrument that pays nothing until maturity has none of it during the term and concentrates all of it at the maturity date, while a high-coupon callable bond carries the most of it and carries it soonest. Matching the maturity of a holding to the date the money is actually needed removes the question rather than answering it.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own investment schedule and interest work through a trial task before a client engagement depends on it.
