A client is considering a callable bond and is concerned about reinvestment risk if interest rates fall. Why is reinvestment risk particularly relevant for callable bonds during periods of declining interest rates?

Question: A client is considering a callable bond and is concerned about reinvestment risk if interest rates fall. Why is reinvestment risk particularly relevant for callable bonds during periods of declining interest rates?

Answer options:

• The bond's price will fall significantly, forcing the client to sell at a loss. ✅ If the bond is called, the client will have to reinvest the proceeds at lower prevailing interest rates.
• Callable bonds typically offer lower coupon rates than non-callable bonds, leading to lower income.
• The yield curve will invert, making it difficult to find suitable investments.

Correct answer: If the bond is called, the client will have to reinvest the proceeds at lower prevailing interest rates.

Explanation: If interest rates fall, the issuer has a strong incentive to call the bond. The client receives the principal back but must then reinvest those funds at the now lower market interest rates, resulting in reduced future income, which defines reinvestment risk.