What is Interest Rate Risk
The interest rate risk, or market risk, refers to the chance that investments in bonds – also known as fixed-income securities – will suffer as the result of unexpected interest rate changes. However, investors can somewhat mitigate interest rate risks by diversifying portfolios to include a multitude of different bonds that have varying maturation schedules. Investors may also thwart interest rate risk by hedging their fixed-income investments with interest rate swaps and other instruments.
Interest Rate Risk
BREAKING DOWN Interest Rate Risk
While interest rate risk may indirectly impact stocks, it primarily affects the value of bonds, and should therefore be carefully monitored by bondholders, above all other investors. Simply put: as interest rates rise, bond prices fall, and vice versa. Why does this happen? Theoretically, as interest rates increase, the opportunity cost – or the cost of missing investments of potentially greater value – of holding money increases, as investors are losing out on the rate of interest earned on bonds and other investments.
Still, because bonds have a fixed coupon rate, when interest rates increase above this fixed level, investors are able to realize greater yields elsewhere by switching to investments that reflect the higher interest rate. Only by having lower selling prices can past securities with lower rates become competitive with securities issued after market interest rates have turned higher.
If an investor buys a five-year bond that costs $500 with a 3% coupon, interest rates may rise to 4%. In that case, the investor may have difficulty selling the bond when other bond offerings enter the market, with more attractive rates. Older bonds look less attractive as newly issued bonds carry higher coupon rates as well. Furthermore, lower demand may trigger lower prices on the secondary market, and the investor may consequently earn less for the bond on the market than he paid for it.
The reverse is also true. A bond yielding a 5% return holds more value if interest rates decrease below this level, 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.
The value of existing fixed-income securities with different maturities declines by various degrees when market interest rates rise. This phenomenon 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, where one matures in one year and the other matures in 10 years. When market interest rates rise, holders of the one-year security could reinvest in a higher-rate security after having a lower return for only one year. Contrarily, holders of the 10-year security would be stuck with a lower rate for nine 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. Note that the sensitivity occurs at a decreasing rate, meaning that while a 10-year bond is significantly more sensitive than a 1-year bond, a 20-year bond is only slightly less sensitive than a 30-year one.
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 typically higher than rates on shorter-term securities. This extra rate of return is called “maturity risk premium." 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.