Why is the investor of a callable bond exposed to reinvestment risk?

What will be an ideal response?

Reinvestment risk is the risk caused by reinvesting fixed payments at a lower rate due to an environment of declining interest rates. The investor of a callable bond is exposed to this risk because as interest rates fall there is a greater likelihood that the callable bond will be called by the issuing firm. More details are given below.

The characteristics of a callable bond can work to the disadvantage of an investor because the holder of a callable bond has given the issuer the right to call the issue prior to the expiration date. In brief, callable bonds expose bondholders to loss in value because an issuer will call
a bond at a price below its market value. It will do this when the current yield on bonds in the market is lower than the issue's coupon rate. For example, if the coupon rate on a callable corporate bond is 12% and prevailing market yields are 8%, the issuer may find it economical to call the 12% issue and refund it with an 8% issue. From the investor's perspective, the proceeds received will have to be reinvested at a lower interest rate. This is called reinvestment risk. Relatedly, the price appreciation potential for a callable bond in a declining interest-rate environment is limited. This is because the market will increasingly expect the bond to be redeemed at the call price as interest rates fall. This phenomenon for a callable bond is referred to as price compression. Because of the disadvantages associated with callable bonds, these instruments often feature a period of call protection, an initial period when bonds may not be called. Also, the investor receives compensation in the form of a higher potential yield.