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The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as "bonds."

When an investor purchases a given corporate bond, for instance, they are actually purchasing a portion of a company's debt. This debt is issued with specific details regarding periodic coupon payments, the principal amount of the debt and the time period until the bond's maturity.

The Inverse Relation with Interest Rates

Another concept that is important for understanding interest rate risk in bonds is that bond prices are inversely related to interest rates. When interest rates go up, bond prices go down, and vice versa. (If you are unfamiliar with this concept, see Why do interest rates tend to have an inverse relationship with bond prices?)

There are two primary reasons why long-term bonds are subject to greater interest rate risk than short-term bonds:

  • There is a greater probability that interest rates will rise (and thus negatively affect a bond's market price) within a longer time period than within a shorter period. As a result, investors who buy long-term bonds but then attempt to sell them before maturity may be faced with a deeply discounted market price when they want to sell their bonds. With short-term bonds, this risk is not as significant because interest rates are less likely to substantially change in the short term. Short-term bonds are also easier to hold until maturity, thereby alleviating an investor's concern about the effect of interest rate driven changes in the price of bonds.
  • Long-term bonds have greater duration than short-term bonds. Because of this, a given interest rate change will have greater effect on long-term bonds than on short-term bonds. This concept of duration can be difficult to conceptualize, but just think of it as the length of time that your bond will be affected by an interest rate change. For example, suppose interest rates rise today by 0.25%. A bond with only one coupon payment left until maturity will be underpaying the investor by 0.25% for only one coupon payment. On the other hand, a bond with 20 coupon payments left will be underpaying the investor for a much longer period. This difference in remaining payments will cause a greater drop in a long-term bond's price than it will in a short-term bond's price when interest rates rise.

How Interest Rate Risk Impacts Bonds

Interest rate risk arises when the absolute level of interest rates fluctuate. Interest rate risk directly affects the values of fixed income securities. Since interest rates and bond prices are inversely related, the risk associated with a rise in interest rates causes bond prices to fall and vice versa.

Interest rate risk affects the prices of bonds, and all bondholders face this type of risk. As mentioned above, it's important to remember that as interest rates rise, bond prices fall. When interest rates rise and new bonds with higher yields than older securities are issued in the market, investors tend to purchase the new bond issues to take advantage of the higher yields.

For this reason, the older bonds based on the previous level of interest rate have less value, and so investors and traders sell their old bonds and the prices of those decrease.

Conversely, when interest rates fall, bond prices tend to rise. When interest rates fall and new bonds with lower yields than older fixed-income securities are issued in the market, investors are less likely to purchase new issues. Hence, the older bonds that have higher yields tend to increase in price.

For example, assume the Federal Open Market Committee (FOMC) meeting is next Wednesday and many traders and investors fear interest rates will rise within the next year. After the FOMC meeting, the committee decides to raise interest rates in three months. Therefore, the prices of bonds decrease because new bonds are issued at higher yields in three months.

How Investors Can Reduce Interest Rate Risk

Investors can reduce interest rate risk with forward contracts, interest rate swaps and futures. Investors may desire reduced interest rate risk to reduce uncertainty of changing rates affecting the value of their investments. This risk is greater for investors in bonds, real estate investment trusts (REITs) and other stocks in which dividends make up a healthy portion of cash flows.

Primarily, investors are concerned about interest rate risk when they are worried about inflationary pressures, excessive government spending or an unstable currency. All of these factors have the ability to lead to higher inflation, which results in higher interest rates. Higher interest rates are particularly deleterious for fixed income, as the cash flows erode in value.

Forward contracts are agreements between two parties with one party paying the other to lock in an interest rate for an extended period of time. This is a prudent move when interest rates are favorable. Of course, an adverse effect is the company cannot take advantage of further declines in interest rates. An example of this is homeowners taking advantage of low interest rates by refinancing their mortgages. Others may switch from adjustable rate mortgages to fixed rate mortgages as well.

Interest rate swaps are agreements between two parties in which they agree to pay each other the difference between fixed interest rates and floating interest rates. Basically, one party takes on the interest rate risk and is compensated for doing so.

Futures are similar to forward contracts and interest rate swaps, except there is an intermediary. This makes the arrangement more expensive, though there's less of a chance of one party failing to meet obligations. This is the most liquid option for investors.

(For further reading, see The Basics of the Bond Ladder, Trying to Predict Interest Rates and Evaluating Bond Funds: Keeping it Simple.)

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