Reinvestment is the process of investors of equity or fixed income securities reinvesting the intermediate disbursements they receive from their investment in the form of dividends, interests or coupon payments, capital gains, bonus, etc. to buy more units of the same investment be it a stock or bond or any other security.
Reinvestment in case of fixed income securities like bonds is very critical because bonds have a fixed and assured payment schedule of regular coupon payments. The YTM or Yield-to-maturity of a bond is the expected return an investor can get by holding the bond to maturity and reinvesting all coupon payments at the YTM. The investor must reinvest all the coupon payments he/she receives from the bond at the available interest rate which may be different from the coupon rate of the bond.
Assume an investor has bought bonds of Energy Grid Pvt. Ltd. with face value of ` 1,000 that have a maturity of 3 years and a coupon payment of 10% paid semiannually. The investor will get ` 50 as coupon payment every six months which must be reinvested back at the available interest rate. If interest rates in the market falls and hence newly issued bonds of Energy Grid are offering 8% coupon, then the investor ends of reinvesting the ` 50 coupon amount in the newly issued bonds offering a 2% lower coupon. Reinvesting here would mean additional units of the bond are bought for ` 50. The current market price of the bonds at this point would be lower than its face value of ` 1,000 since the bonds are offering a lower coupon (8%) than the previously issued bonds (10%).
Thus in case of bond investment, investors are prone to interest rate fluctuations while reinvesting their coupon proceeds until the maturity of the bonds when they finally get back their principal.