What is reinvestment risk in the context of bonds?

• A. The risk that principal will not be repaid
• B. The risk that future coupon payments will have to be reinvested at lower rates, reducing returns
• C. The risk that inflation outpaces returns
• D. The risk of default

Answer: (B)

Reinvestment risk is the possibility that the cash you receive from a bond’s periodic coupon payments will have to be reinvested at lower interest rates than the bond’s original yield, which reduces your overall return. In other words, even though the bond pays a fixed rate, the amounts you reinvest over time may earn less than expected if market rates fall. This risk is larger for bonds with more coupon payments and longer times to maturity because there are more opportunities to reinvest cash flows. If rates drop after you buy the bond, your future coupons earn less when reinvested, lowering the realized yield compared with the stated yield. If rates rise, reinvestment risk is less harmful, but it can still affect the total return because reinvested funds may not match the original rate. This issue focuses on cash flows from coupons, not on whether the principal will be repaid or on inflation or default risks.