Reinvestment risk

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Reinvestment risk

The risk that proceeds received in the future may have to be reinvested at a lower potential interest rate.

Reinvestment Risk

A risk that an investment, usually a bond, will be paid off early and that the money earned may not be able to be reinvested in a security with a comparable return. Suppose one invested in a bond with coupon payment of 4%. However, the issuer calls the bond and pays the par value. The investor has made a profit, but interest rates have fallen and now he/she may only purchase a bond with coupons of 2.5%. Theoretically, one might purchase a mortgage-backed security or other investment in which all the mortgage holders backing the MBS may pay back their mortgages early, exposing one to reinvestment risk. However, in reality, this risk exists primarily in callable bonds and certificates of deposit.

reinvestment risk

The possibility that the cash flows produced by an investment will have to be reinvested at a reduced rate of return. For example, the owner of a certificate of deposit faces the risk that lower interest rates will be in effect when the certificate matures and the funds are to be reinvested.

Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.

Reinvestment risk.

Reinvestment risk occurs when you have money from a maturing fixed-income investment, such as a certificate of deposit (CD) or a bond, and want to make a new investment of the same type.

The risk is that you will not be able to find the same rate of return on your new investment as you were realizing on the old one. In fact, the return could be significantly lower, based on what's happening in the economy at large, though it could also be higher.

For example, if a bond paying 6% interest matures when the current rate is 4%, you must settle for a lower return if you buy a new bond unless you're willing to buy one of lower quality.

One way to limit reinvestment risk is by using an investment technique known as laddering, which means splitting your investment among a number of bonds or CDs that mature gradually over a series of years.

That way only part of your total investment will mature and have to be reinvested at any one time.

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It's relatively constant because a market rate change causes an equal and opposite reaction in the price and reinvestment risks. The interest's future value increases as rates increase, but the increase is offset by a decrease in the bond's sales price at the investment horizon's end.

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