Loading the player...

What is the 'Interest Rate Risk'

The interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (such as through an interest rate swap).

BREAKING DOWN 'Interest Rate Risk'

Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall, and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases, since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease, since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

Market Interest Rates

Interest rate risk is most relevant to fixed-income securities whereby a potential increase in market interest rates is a risk to the value of fixed-income securities. When market interest rates increase, prices on previously issued fixed-income securities as traded in the market decline, since potential investors are now more inclined to buy new securities that offer higher rates. Only by having lower selling prices can past securities with lower rates become competitive with securities issued after market interest rates have turned higher.

Price Sensitivity

The value of existing fixed-income securities with different maturities declines by various degrees when market interest rates rise. This is referred to as price sensitivity, meaning that prices on securities of certain maturity lengths are more sensitive to increases in market interest rates, resulting in sharper declines in their security values.

For example, suppose there are two fixed-income securities, one maturing in one year and the other in 10 years. When market interest rates rise, holders of the one-year security could quickly reinvest in a higher-rate security after having a lower return for only one year. Holders of the 10-year security would be stuck with a lower rate for 9 more years, justifying a comparably lower security value than shorter-term securities to attract willing buyers. The longer a security's maturity, the more its price declines to a given increase in interest rates.

Maturity Risk Premium

The greater price sensibility of longer-term securities leads to higher interest rate risk for those securities. To compensate investors for taking on more risk, the expected rates of return on longer-term securities are normally higher than on shorter-term securities. This extra rate of return is called maturity risk premium, which is higher with longer years to maturity. Along with other risk premiums, such as default risk premiums and liquidity risk premiums, maturity risk premiums help determine rates offered on securities of different maturities beyond varied credit and liquidity conditions.

RELATED TERMS
  1. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic ...
  2. Interest Rate Sensitivity

    A measure of how much the price of a fixed-income asset will ...
  3. Bond Ladder

    A portfolio of fixed-income securities in which each security ...
  4. Contraction Risk

    The risk faced by the holder of a fixed income security when ...
  5. Reinvestment Rate

    The amount of interest that can be earned when money is taken ...
  6. Basis Price

    Price quotation for a security expressed in terms of yield to ...
Related Articles
  1. Financial Advisor

    How to Protect IRAs from Higher Interest Rates

    Rising interest rates don’t have to translate into investment losses in an IRA. Here's how you can protect your investments.
  2. 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.
  3. Investing

    How Interest Rates Affect Mutual Funds

    Find out how changing interest rates impact mutual funds, including bond and money market funds, and how higher rates can discourage investors.
  4. Investing

    How Rising Interest Rates and Inflation Affect Bonds

    Understand bonds better with these four basic factors.
  5. Investing

    What Investors Should Know About Interest Rates

    Understanding interest rates helps you answer the fundamental question of where to put your money.
  6. Investing

    Understanding Interest Rates, Inflation And Bonds

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

    Lowering Portfolio Volatility With Certain Bond ETFs (AGG, BND)

    Learn about how overall portfolio risk can be reduced by adding a variety of different types of bond ETFs to a primarily stock portfolio.
  8. Investing

    What's a Debt Security?

    A debt security is a financial instrument issued by a company (usually a publicly traded corporation) and sold to an investor.
RELATED FAQS
  1. What are the main disadvantages of fixed income securities?

    Learn why fixed-income securities, despite offering the luxury of guaranteed, regular cash payments, confer several disadvantages ... Read Answer >>
  2. What types of investors are susceptible to interest rate risk?

    Learn how bondholders are more susceptible to interest rate risk than equity investors because of the direct correlation ... Read Answer >>
  3. How can an investor reduce interest rate risk?

    Learn about the different ways investors can reduce interest rate risk. Locking in interest rates increases certainty for ... Read Answer >>
  4. How do I evaluate a debt security?

    Look at a brief overview of the important factors to consider before purchasing a debt security, such as a corporate or government ... Read Answer >>
Hot Definitions
  1. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
  2. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
  3. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  4. Backward Integration

    A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it ...
  5. Pari-passu

    A Latin phrase meaning "equal footing" that describes situations where two or more assets, securities, creditors or obligations ...
  6. Interest Rate Swap

    An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for ...
Trading Center