4 types of interest rate risk

Interest rate risk is the potential for investment losses that can be triggered by a move upward in the prevailing rates for new debt instruments. If interest rates rise, for instance, the value of a bond or other fixed-income investment in the secondary market will decline. The change in a bond's price given a change in interest rates is known as its duration.

Interest rate risk can be reduced by buying bonds with different durations, or by hedging fixed-income investments with interest rate swaps, options, or other interest rate derivatives.

Key Takeaways

• 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.
• Interest rate risk is measured by a fixed income security's duration, with longer-term bonds having a greater price sensitivity to rate changes.
• Interest rate risk can be reduced through diversification of bond maturities or hedged using interest rate derivatives.

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Interest Rate Risk

Understanding Interest Rate Risk

Interest rate changes can affect many investments, but it impacts the value of bonds and other fixed-income securities most directly. Bondholders, therefore, carefully monitor interest rates and make decisions based on how interest rates are perceived to change over time.

For fixed-income securities, as interest rates rise security prices fall (and vice versa). This is because when interest rates increase, the opportunity cost of holding those bonds increases – that is, the cost of missing out on an even better investment is greater. The rates earned on bonds therefore have less appeal as rates rise, so if a bond paying a fixed rate of 5% is trading at its par value of $1,000 when prevailing interest rates are also at 5%, it becomes far less attractive to earn that same 5% when rates elsewhere start to rise to say 6% or 7%.

In order to compensate for this economic disadvantage in the market, the value of these bonds must fall, because who will want to own a 5% interest rate when they can get 7% with some different bond.

Therefore, for bonds that 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.

Interest rate risk can be managed through hedging or diversification strategies that reduce a portfolio's effective duration or negate the effect of rate changes. (For more on this, seeManaging interest rate risk.)

Example of Interest Rate Risk

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” and is measured by the bond's duration.

For instance, 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

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. The larger duration 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.

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