What does rate risk mean?
Interest rate risk is when rates for new debt instruments go up, there is a chance that investments will lose money. If interest rates go up, a bond or other fixed-income purchase will lose value on the secondary market. This is the amount that the price of a bond changes when interest rates change.
You can buy bonds with different terms or protect your fixed-income investments with interest-rate swaps, options, or other products to lower interest-rate risk.
How to Understand Interest Rate Risk
Changing interest rates can affect many investments, but they have the most direct effect on the value of bonds and other fixed-income assets. Because of this, bondholders keep a close eye on interest rates and base their decisions on how they think rates will change over time.
When interest rates go up, the prices of fixed-income assets go down; when they go down, interest rates go up. This is because the potential cost of holding those bonds increases when interest rates increase. This means that it costs more to miss out on a better investment. Because of this, bond rates become less appealing as rates rise. For example, if a bond with a fixed rate of 5% is trading at $1,000 when rates are also 5%, it becomes much less appealing to make that same 5% when rates rise to 6% or 7%.
For the market to make up for this economic loss, the value of these bonds needs to go down. After all, who would want to own a bond with a 5% interest rate when they can get one with a 7% rate?
With this in mind, investors move their money from fixed-rate bonds to investments that pay a higher interest rate when interest rates rise above the set level. Securities released before the change in interest rates can only compete with new issues if their prices go down.
Interest rate risk can be controlled by hedging or diversification, which shortens the effective length of a portfolio or makes rate changes less critical. How to handle interest rate risk has more information on this.
- Use fake money to practice the trade.
- Pick a date to buy. Two years ago, five years, ten years ago
- DO THE WORK
A Case of Interest Rate Risk
Suppose a person buys a $500 bond with a 3% yield due in five years. After that, rates go up to 4%. When new bonds with better rates come out, the owner will have difficulty selling the old ones. In the secondary market, prices also decrease because there is less desire. The bond’s market value could fall below the amount it was bought for.
It works the other way too. If interest rates drop below 5%, a bond with a 5% return is worth more because the bondholder gets a set return rate higher than the market rate.
How Bond Prices Are Affected
When market interest rates go up, the value of current fixed-income securities with different maturity dates goes down differently. This is called “price sensitivity,” and the length of the bond is a way to measure it.
What if there are two fixed-income securities? One will mature in one year and the other in ten years. People who own one-year securities can reinvest in a higher-rate security when market interest rates increase. They can do this after holding on to the bond with the smaller return for no more than one year. But the person who owns the 10-year bond will have to pay a lower rate for nine more years.
That’s why the longer-term security should have a smaller price value. When interest rates go up, the price of an investment goes down more as the time to maturity gets longer.
Keep in mind that this price sensitivity is happening less quickly. However, a 20-year bond is slightly less sensitive than a 30-year bond. A 10-year bond is much more sensitive than a one-year bond.
The risk premium for maturity
Long-term bonds usually have a higher rate of return built-in to make up for the higher risk of interest rates changing over time. This is called a maturity risk premium. Longer-term securities have a higher interest rate risk because they have a longer life. Longer-term securities usually have higher expected rates of return than shorter-term securities. This is done to make up for the fact that buyers are taking on more risk. The age risk premium is the name for this amount.
Bond rates may also be based on other risk premiums, like liquidity risk premiums and failure risk premiums.
Conclusion
- Interest rate risk is the chance that a change in interest rates will make a bond or other fixed-rate investment worth less:
- Bond prices go down as interest rates go up, and vice versa. This means that the market price of old bonds goes down to balance out the higher rates on new bonds.
- The length of a fixed-income security shows how risky it is for interest rates to change. Bonds with longer terms are more sensitive to changes in interest rates.
- Diversifying the terms of bonds or using interest rate derivatives to protect against interest rate risk are two ways to lower interest rate risk.
