Interest rate risk is concerned with a decline in the price of a bond or a portfolio of bonds due to an increase in market rates. As rates increase, bond prices decline and vice versa.

The features of a bond affect the bond's interest rate in the following ways:

  • Maturity - The longer the maturity of the bond, the more sensitive it is to interest rate movements. The reason for this effect is that more cash flows will be affected over a longer period of time.
  • Coupon Rates - Lower coupon rates are more sensitive to interest rates. Why? If your bond is paying 4% and rates are in an upward swing, the difference in the market yield and your yield will continue to widen, which will push your bond values down.
  • Embedded Options - As interest rates decline the value of the option becomes more valuable to the issuing company. The price will increase as rates decline but will be held at the call or redemption price. This is because as rates decline it will become more likely that the issuer will call the bonds and that the holder will only receive the call price and not a true market price. Likewise, when rates rise the price will not drop as much because the option will maintain some sort of value when compared to a bond with no options.


Look Out!

Recognize that the various bond features work with or against each other in determining a bond's price volatility.

As market yield volatility increases, the interest rate risk increases. This is because there is a greater chance of rates breaking out of their current ranges, either by rising or declining. Typically, as rates increase there is a greater chance of this risk occurring because market prices of bonds will decline as interest rates rise.



Call and Prepayment Risk

Related Articles
  1. Investing

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  2. Investing

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  3. Investing

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  4. Investing

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  5. Financial Advisor

    The Effect of Fed Fund Rate Hikes on Your Bond Portfolio

    Learn how an increase in the federal funds rate may impact a bond portfolio. Read about how investors can use the duration of their portfolio to reduce risk.
  6. Investing

    5 Reasons to Invest in Municipal Bonds When the Fed Hikes Rates

    Discover five reasons why investing in municipal bonds after the Fed hikes interest rates, and not before, can be a great way to boost investment income.
  7. Financial Advisor

    Rising Rates: What It'll Mean for Stocks and Bonds

    A look at what rising interest rates could mean for the equity and bond markets.
  8. Investing

    How Rising Interest Rates Affect Junk Bonds

    We examine the impact of rising interest rates on higher-yielding bonds.
  9. Investing

    How Does A Bond’s Coupon Interest Rate Affect Its Price?

    All bonds come with a coupon interest rate, which is the fixed annual interest a bond pays.
  10. Investing

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
Trading Center