What Is Interest Rate Risk?
Interest rate risk is the danger that the value of a bond or other fixed-income investment will suffer as the result of a change in interest rates. Investors can reduce interest rate risk by buying bonds that mature at different dates. They also may allay the risk by hedging fixed-income investments with interest rate swaps and other instruments.
A long-term bond generally offers a maturity risk premium in the form of a higher built-in rate of return to compensate for the added risk of interest rate changes over time.
Interest Rate Risk
Understanding Interest Rate Risk
Interest rate risk indirectly affects many investments, but it directly affects the value of bonds. Bondholders, above all investors, carefully monitor interest rates.
- Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment.
- As interest rates rise bond prices fall, and vice versa.
- This means that the market price of existing bonds drops to offset the more attractive rates of new bond issues.
- Long-term bonds often have a maturity risk premium to offset the potential downside of interest rate changes.
Simply put, as interest rates rise bond prices fall, and vice versa. When interest rates increase, the opportunity cost–that is, the cost of missing out on an even better investment–increases. The rates earned on bonds have less appeal.
Bonds have a fixed rate. When interest rates rise to a point above that fixed level, investors switch to investments that reflect the higher interest rate. Securities that were issued before the interest rate change can compete with new issues only by dropping their prices.
Bond investors reduce interest rate risk by buying bonds that mature at different dates.
For example, say an investor buys a five-year, $500 bond with a 3% coupon. Then, interest rates rise to 4%. The investor will have trouble selling the bond when newer bond offerings with more attractive rates enter the market. The lower demand also triggers lower prices on the secondary market. The market value of the bond may drop below its original purchase price.
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 favorable fixed rate of return relative to the market.
Bond Price Sensitivity
The value of existing fixed-income securities with different maturity dates declines by varying degrees when market interest rates rise. This phenomenon is referred to as “price sensitivity.”
For example, suppose there are two fixed-income securities, one that matures in one year and another that matures in 10 years. When market interest rates rise, the owner of the one-year security can reinvest in a higher-rate security after hanging onto the bond with a lower return for only one year at most. But the owner of the 10-year security is stuck with a lower rate for nine more years.
That justifies a lower price value for the longer-term security. The longer a security's time to maturity, the more its price declines relative to a given increase in interest rates.
Note that this price sensitivity occurs at a decreasing rate. A 10-year bond is significantly more sensitive than a one-year bond but a 20-year bond is only slightly less sensitive than a 30-year one.
The Maturity Risk Premium
The greater price sensibility of longer-term securities means 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 is known as the maturity risk premium.
Other risk premiums, such as default risk premiums and liquidity risk premiums, may determine rates offered on bonds.