Reinvestment Risk

Reinvestment risk is the risk that:

1. A.The bond is calledThis is call risk, and the two are closely linked: issuers call bonds when rates fall, forcing the investor to reinvest at those lower rates. The call is the trigger, while reinvestment risk is the underlying exposure and exists for ordinary coupons on noncallable bonds too.
2. B.Coupons must be reinvested at lower ratesCorrect - falling rates hurt reinvestment.
3. C.The issuer defaultsDefault is credit risk, concerning whether the promised payments arrive at all. Reinvestment risk assumes the payments do arrive and asks what rate they can be redeployed at.
4. D.Inflation disappearsFalling inflation is generally favorable for a bondholder's purchasing power. Reinvestment risk concerns the level of interest rates available on future cash flows, not the behavior of prices.

Why: Reinvestment risk is that a bond's coupon payments must be reinvested at lower prevailing rates.

Corvin holds a bond fund and asks what will happen to his income if interest rates fall substantially over the next several years and stay low. His representative should explain that he is primarily exposed to:

1. A.Interest rate risk, because falling rates reduce the market value of the fund's existing bonds.Falling rates raise the prices of existing bonds. Interest rate risk is the exposure to RISING rates.
2. B.Credit risk, because issuers are more likely to default in a low rate environment.Low rates generally ease issuers' borrowing costs; they do not create the exposure Corvin is asking about.
3. C.Reinvestment risk, because maturing and called bonds must be replaced at lower prevailing rates.Correct. Sustained lower rates mean proceeds are reinvested at lower yields, gradually reducing the fund's income.
4. D.Purchasing power risk, because a low rate environment always accompanies high inflation.Low rates do not imply high inflation, and purchasing power risk is a separate concept from the income effect described.

Why: Reinvestment risk is the risk that interest and principal coming back to the investor must be put to work at lower prevailing rates. Inside a bond fund, maturing and called bonds are continually replaced, so a sustained decline in rates gradually lowers the income the fund can distribute even though the market value of the existing bonds initially rises.

A client owns a callable corporate bond purchased at a premium. Rates fall and the issuer calls the bond. Which statement best describes what has happened to her?

1. A.The issuer defaulted on its obligation, so the client has suffered credit risk.Wrong. Exercising a contractual right is the opposite of a default, and the issuer paid exactly what it promised.
2. B.The client loses an above-market coupon and must reinvest at lower rates.Correct. Issuers call when they can refinance more cheaply, which is exactly when the holder least wants the cash back.
3. C.The client benefits, because a call is exercised only when a bond is worth less.Wrong. The call comes when the bond has become valuable to the holder, which is why the issuer wants it retired.
4. D.The client is unaffected, because the call price was disclosed at issuance.Wrong. Disclosure at issuance explains why the call was permitted, not why the holder is worse off for it.

Why: A call provision lets the issuer retire the bond early, and issuers exercise it when rates have fallen far enough to refinance at a lower coupon. From the holder's side the timing is uniformly unfavorable: the attractive above-market coupon disappears and the proceeds can be reinvested only at the new lower rates. The exposure is closely related to reinvestment risk and is driven by market-wide rate moves rather than by anything peculiar to the issuer. A holder who wants to avoid it should seek call protection or buy non-callable issues.

A representative explains that two bond risks pull in opposite directions as rates move. Which pairing correctly states which risk bites when rates rise and which bites when rates fall?

1. A.Rising rates create reinvestment risk; falling rates create interest rate risk.Wrong. This reverses the pair, attaching the price decline to the wrong direction of rate change.
2. B.Rising rates create interest rate risk; falling rates create reinvestment risk.Correct. Higher rates push outstanding bond prices down, while lower rates force coupons into less rewarding reinvestments.
3. C.Both risks bite when rates rise, and neither is present when rates fall.Wrong. Falling rates are exactly when reinvestment becomes a problem, so it cannot be absent from that case.
4. D.Both risks bite when rates fall, and neither is present when rates rise.Wrong. Rising rates depress the price of every outstanding fixed-rate bond, so that direction is far from harmless.

Why: Interest rate risk is about market value: when yields rise, an outstanding bond with a fixed coupon must fall in price to stay competitive. Reinvestment risk is about income: when yields fall, each coupon and each maturing principal payment can be redeployed only at a lower rate. Because the two respond to opposite moves, no single rate environment is comfortable for every objective. A holder who intends to keep a bond to maturity is largely indifferent to the price effect but fully exposed to the reinvestment effect.