Canadian Securities Course (CSC) Level 1 Practice Exam

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What does reinvestment risk in bonds entail?

  1. Greater returns from reinvesting coupons with higher interest rates

  2. Earning less from reinvesting coupons than the original purchase rate

  3. Increased risk due to fluctuating bond prices

  4. Increased liquidity making reinvestment challenging

The correct answer is: Earning less from reinvesting coupons than the original purchase rate

Reinvestment risk in bonds refers specifically to the potential scenario where an investor may have to reinvest the cash flows received from the bond, such as interest payments (coupons), at a lower interest rate than the original bond. This situation arises when market interest rates decline after the bond's purchase, which means that when the investor receives coupon payments, they may only be able to reinvest those payments in new bonds or interest-bearing securities that offer lower yields. As a result, the overall return on the investment can diminish since the investor is earning less on the reinvested coupons than initially projected when they purchased the bond, which is a core aspect of reinvestment risk. This is why the correct answer highlights the risk of earning less from reinvesting coupons compared to the original purchase rate. The other options do not accurately capture this specific risk associated with the reinvestment of bond coupons.

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