Interest rate risk is the potential for investment losses triggered by a rise in prevailing rates for new debt instruments. When interest rates increase, the value of bonds or other fixed-income investments in the secondary market declines. This change in a bond’s price relative to interest rate changes is known as its duration.
Interest rate risk can be mitigated by holding bonds with varying durations, or by hedging fixed-income investments using interest rate swaps, options, or other derivatives.
Key Takeaways
- Interest rate risk can reduce the value of a bond or other fixed-rate investments when overall interest rates change.
- As interest rates rise, bond prices fall, and vice versa, because new bonds offer more attractive rates.
- The sensitivity of a bond’s price to interest rate changes is measured by its duration. Longer-term bonds are more sensitive to rate changes.
- Diversification of bond maturities, or use of derivatives, can help manage interest rate risk.
Understanding Interest Rate Risk
Interest rate fluctuations impact many investments, but the effect is most direct on bonds and other fixed-income securities. Bondholders, therefore, closely track interest rates and make decisions based on anticipated changes.
For fixed-income securities, a rise in interest rates causes security prices to fall (and vice versa). As higher rates increase the opportunity cost of holding lower-yielding bonds, investors may find better returns elsewhere, leading to a drop in bond demand and prices.
To remain competitive when interest rates increase, the market price of existing bonds must decrease. Therefore, bonds with a fixed rate become less appealing as rates rise, causing a migration to newer, higher-rate investments.
Hedging or diversifying strategies can manage interest rate risk by reducing a portfolio’s effective duration or offsetting rate changes’ effects.
Example of Interest Rate Risk
Imagine an investor purchases a five-year, $500 bond with a 3% coupon rate. Later, interest rates rise to 4%. The bond’s attractiveness dwindles against newer issues offering better returns, which suppresses its market value.
Conversely, a bond offering a 5% return gains value if interest rates fall below that level, providing the bondholder with a rate of return superior to newer bonds.
Bond Price Sensitivity
As market interest rates rise, the value of existing fixed-income securities with different maturities decreases to varying degrees — a phenomenon termed “price sensitivity,” measured by the bond’s duration.
For example, suppose there are two bonds, one maturing in a year and another in 10 years. The one-year bondholder can reinvest in a higher-rate bond after a short duration, while the 10-year bondholder is locked in at a lower rate for longer, reducing its price value considerably. The longer the bond’s maturity, the more sensitive its price is to interest rate hikes.
Note that price sensitivity diminishes at a decreasing rate. So, a 10-year bond is much more sensitive than a one-year bond, but a 20-year bond is only marginally less sensitive than a 30-year bond.
The Maturity Risk Premium
Long-term bonds typically offer a maturity risk premium, providing a higher built-in rate of return to offset the added risk of rate changes over time. Higher interest rate risk for longer-term securities necessitates greater returns compared to shorter-term securities — this differential is termed the maturity risk premium.
Various other risk premiums — including default risk premiums and liquidity risk premiums — may also influence bond rates.
Related Terms: Duration, Fixed-Income Securities, Interest Rate Derivatives, Coupon Rate.
