What Is Rate Level Risk?
Rate level risk is the possibility that an interest-bearing asset will lose value if market interest rates increase above its coupon rate.
- Rate level risk is the risk of an interest-bearing asset losing value in the case that market interest rates rise above its coupon rate.
- Interest rate risk is one of the main factors affecting bond prices and typically increases with duration.
- When market interest rates increase and cross the level of the coupon rate, the value of a bond will decrease and the investor stands to lose value on their investment.
Understanding Rate Level Risk
Interest rate risk is one of four main factors affecting bond prices and typically increases with duration, a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates, stated in terms of years.
When a government or business issues fixed-income securities, the price and coupon are set by the issuer to be competitive within the current rate environment. Bonds will be offered at prices based on term structure and corresponding rates across the current yield curve. As interest rates vary going forward, prices of existing bonds will fluctuate accordingly. When interest rates increase, bond prices fall, and when interest rates decrease, bond prices rise.
When interest rates fall, holders of bonds and other fixed-income securities will typically see the value of their holding increase, even though the coupon rate is fixed. They may be able to sell their bond for a higher price than they paid for it. However, when rates increase, the value of a bond, or portfolio of bonds that have been issued at correspondingly lower rates, will decrease. When the market interest rate increase crosses the level of the fixed-income investment's coupon rate, the investor stands to lose value. This will be readily apparent in the daily pricing of bond mutual funds. For example, during a period when longer-term rates are rising, a bond portfolio that has a concentration in longer-term bonds will see its value drop.
Investors who own individual bonds can hold their bonds to maturity (unless the bond has a call feature and is called) and receive the full return that the bond originally offered, barring a default. This assumes that the investor is comfortable with earning less than what may be available in the current market. For managers of large bond portfolios, rising rate levels have a significant effect on the value of the portfolio and the ability of the manager to attract and retain investors. For this reason, professional bond managers typically trade more frequently than individual bondholders in order to produce competitive pricing and yields for the portfolio.