Fixed Income Investments - Interest Rate Risk
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.
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