Interest Rate Risk
It is an investor's risk when holding an asset whose value is derived from interest rates, such as a bond
What Is Interest Rate Risk?
Interest rate risk is an investor's risk when holding an asset whose value is derived from interest rates, such as a bond. The price of bonds is inversely proportional to interest rates, so the price will go down if interest rates go up.
However, this risk can be mitigated using inversely correlated assets, diversification, and hedged derivatives.
Most interest rate risk analysis is based on modeling movements in one or more yield curves utilized with the Heath-Jarrow-Morton framework. This ensures that the movements in yield curves are consistent with existing market yield curves and do not allow for riskless arbitrage.
Investments that depend on a certain rate of interest may be impacted by changes in that rate more so than investments that depend less on external factors like inflation and economic growth rates. Because of this, when standard interest rates climb or decrease, some assets become much more appealing due to higher yields, while others lose value due to decreasing returns.
Short-term bonds have a lower interest rate risk since the changes in the interest rates would only affect the bonds for a shorter period of time.
On the other hand, long-term bonds carry a higher interest rate risk because an unfavorable interest rate change can occur for several years.
Because longer-term bonds are subject to higher interest rate risk, their expected rate of return is often higher than that of shorter-term bonds, often known as the maturity risk premium.
Key Takeaways
- The risk associated with interest rates is the possibility that a change in rates will reduce the value of bonds or other fixed-rate investments:
- Bond prices go down as interest rates go up. As a result, the price of existing bonds drops to counteract the higher rates of new bonds.
- The duration of fixed income security determines its interest rate risk, with longer-term bonds being more sensitive to rate changes.
- It's possible to reduce interest rate risk by diversifying into bonds with different maturities, hedging with interest rate derivatives, or using inversely correlated assets.
Understanding interest rate risk
Let's examine the risks associated with rising interest rates. Suppose you bought a 10-year bond today with a coupon rate of 4 percent, and rates go up to 7 percent.
If you want to sell your 4 percent bond before it matures, you'll have to compete with newer bonds with higher coupons. This is because bonds with higher coupon rates decrease the demand for older bonds that pay lower interest rates.
Reduced demand depresses the price of older securities on the secondary market, resulting in a lower sale price for your bonds if you need to sell them.
You may be forced to sell your bond for a lower price than you paid.
For this reason, this risk is sometimes referred to as market risk. Additionally, rising interest rates make new bonds more attractive (since they earn a higher coupon rate). The result is what's known as opportunity risk, which is the risk that you might miss out on a better opportunity.
A more favorable investment opportunity will likely arise during the term of your enduring bond, and the possibility of other factors negatively impacting your investment.
Also known as holding period risk, this is the possibility that not only may a better opportunity be missed but also that something may occur during the holding period that will adversely affect your investment.
Bond fund managers are subject to the same risks as individual bondholders. The value of the fund's existing bonds falls when interest rates, rise-especially if they increase rapidly within a short period. This holding period can harm fund performance.
Bond Price Sensitivity & Market Risk Premium
With a rise in market interest rates, the value of fixed-income securities with different maturity dates decreases. It is measured by the bond's duration and is called "price sensitivity."
Imagine two fixed-income securities, one maturing in a year and the other in a decade. Following the rise in market interest rates, the holder of the one-year security may reinvest in a higher-rate bond after holding onto the bond with a lower return for no more than one year.
However, the person who owns the 10-year security has to bear the lower rate for nine more years.
For the longer-term security, a lower price value is established. In addition, the longer the maturity time, the more its value declines relative to an increase in interest rates.
Note that the rate of price sensitivity decreases as time passes. For example, bonds with a term of 10 years are significantly more sensitive than ones with one year, but bonds with a term of 20 years are slightly less sensitive than those with a term of 30 years.
In addition to the added risk of interest rate changes over time, long-term bonds often offer a maturity risk premium in a higher built-in rate of return. Longer-term securities have a higher interest rate risk due to their longer duration.
Typically, longer-term securities offer higher rates of return to compensate investors for taking on more risk. This is called the maturity risk premium.
Ways of mitigating interest rate risk
Different ways are:
1. Diversification
- Suppose a bondholder is concerned about interest rate risk, which could depreciate his portfolio's value. In that case, he can diversify his portfolio by adding assets that are less susceptible to interest rate swings (e.g., equity).
- If the investor has bonds in his portfolio, he can diversify it by having short- and long-term bonds.
2. Hedging
- Interest rate risk can be reduced using a variety of hedging tactics. Investments in various forms of derivatives are a common component of these strategies.
- Interest rate swaps, options, futures, and forward rate agreements (FRAs) are some of the most common.
Investing in bonds of different durations can reduce interest rate risk, as can hedging fixed-income investments with interest rate swaps, options, or other interest rate derivatives.
Precious metal values tend to rise as interest rates rise, so investors can buy them as a hedge against rising rates (before rates begin growing).
Certain types of equities also perform well when interest rates are rising. So it may make sense to shift the weight of a portfolio from bonds to equities.
When interest rates rise, stocks issued by banks, insurance companies, and payroll processing companies perform well. On the other hand, growth stocks perform poorly when interest rates rise because borrowing money becomes more expensive.
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