What it is:
How it works (Example):
For example, consider a Company XYZ bond with a 10% yield to maturity (YTM). In order for an investor to actually receive the expected yield to maturity, she must reinvest the coupon payments she receives at a 10% rate. This is not always possible. If the investor could only reinvest at 4% (say, because market returns fell after the bonds were issued), the investor's actual return on the bond investment would be lower than expected.
Although the primary component of reinvestment risk is the ability to effectively reinvest coupon payments, the probability of losing those coupon payments in the first place also affects reinvestment risk. For example, callable securities (like callable bonds and redeemable preferred stock) carry extra reinvestment risk because if they are called away, the investor will not even collect all the expected interest payments, much less reinvest them effectively.
Remember that issuers usually call bonds when interest rates fall, leaving the investor to reinvest the proceeds at a lower rate. So if Company XYZ's bonds are callable, and rates fall from 10% to 3%, Company XYZ will probably call the 10% bonds and issue new bonds with a lower coupon. The holders of the 10% bonds would receive their principal back (and probably a small call premium), but they would then have to find other investments, none of which would probably pay as well as the Company XYZ bonds.
Why it Matters:
There are some ways to mitigate reinvestment risk. One way is to invest in noncallable securities. This keeps the issuer from calling away high-coupon investments when market rates fall. (Note, however, that the investor must still find effective ways to reinvest those coupon payments in what has become a low-rate environment).
Zero-coupon bonds also help investors reduce their reinvestment risk because zero-coupon bonds don't pay coupons. However, the investor must still decide how to reinvest the proceeds when the bond matures.