Interest rate risk refers to the possibility that a fixed-income asset, such as a bond, could rise or fall in value owing to changing interest rates. Interest rate risk also has implications for businesses.
When interest rates rise, bond values on the secondary market tend to fall, and vice versa: When interest rates decline, bond values tend to rise. A bond’s duration, or maturity, comes into play as well. Bonds with longer durations (i.e., more time to maturity) are more susceptible to interest rate risk.
Interest rate risk also applies to securities such as CDs (which may have floating rates), as well as loans with variable rates. These instruments can have an impact on consumers, as well as companies, who might see their debt payments increase on variable-rate loans, for example.
Key Points
• Interest rate risk usually refers to the impact of interest rate changes on bond values.
• When interest rates rise, bond values tend to fall, and when interest rates drop, bond values rise.
• Longer duration bonds — those with more time to maturity — are more vulnerable to interest rates changes.
• Interest rate risk can also impact stocks indirectly, when a company’s cash flow or performance is impacted by changes in borrowing costs and investment returns.
• Investors with fixed-income investments may seek ways to mitigate interest rate risk.
How Does a Bond Work?
Bonds are a type of loan, with the bond issuer effectively borrowing money from the investor. The issuer could be the federal government, a state or local government, or a company.
In return for the loan, the investor is promised that they will be repaid the full amount of the bond (the principal) — plus a predetermined amount of interest (the coupon rate) — on a specific date.
Traditionally, most bonds have paid a fixed rate, although there are some with a variable or “floating” interest rate.
Bonds come with an expiration or “maturity” date, when the value of the bond must be paid back in full to the investor, plus interest.
While there’s no such thing as a safe investment, investors typically consider bonds to be lower-risk than stocks and some other investments.
Buying and Selling Bonds
An investor can sell a bond before it reaches its full maturity. If the bond issuer is doing well and the bond is in high demand, the investor could sell it on the secondary market and see a capital gain. If not, the sale might be made at a loss.
Because interest rates impact a bond’s value, the risk here is that rising rates could make a bond’s current rate less attractive. By the same token, if interest rates drop, and an investor is holding bonds with a higher rate, the value of those bonds will rise.
Interest Rate Risk and Timing
In other words, when investors buy fixed-rate bonds, they’re taking the risk that the interest rate may go up after they’ve already made their purchase.
If interest rates do increase, then new bonds are issued with higher rates, which means that existing bonds with lower returns are in lower demand, lowering the bonds’ value.
In general, longer-term bonds are more sensitive to interest rate risk than those with shorter terms. The higher interest rates rise after the bond was purchased, the more of an impact that can have on the investor’s return on investment.
Examples of Interest Rate Risk
The Office of Investor Education and Advocacy of the U.S. Securities and Exchange Commission (SEC) offers two contrasting examples to illustrate this concept.
In the first example, they assume that a Treasury bond has a 3% interest rate. A year later, interest rates drop to 2%. But investors who bought their bonds at 3% continue to receive that interest rate, making it a more valuable investment than new bonds paying just 2%.
If that bond is sold before it reaches its maturity date, the price would likely be higher than it was in the previous year. The bond’s yield to maturity, though, will be down for investors purchasing it at the higher price.
In the second example, instead of rates going down from the original 3%, rates go up to 4%. In that scenario, investors looking to sell their bonds would be competing with new bonds that offer a 4% rate. So the price of the bond that pays 3% may well fall, with the yield going up.
How Interest Rates Can Impact Stocks
Stocks can also be subject to interest rate risk, in that rate changes can impact a company’s bottom line via potentially higher borrowing costs, and expected return on investments (including CDs, which can have a variable rate).
While the impact of interest rates on stocks is indirect, interest rate risk is nonetheless a concern for equity investors as well.
Interest Rate Risk Management
One way to handle investment risk is with diversification. This means building a diversified portfolio that includes a variety of different asset classes, such as stocks, mutual funds, real estate or other asset classes.
Diversified investment portfolios may offer some risk insulation so that if one area takes a financial hit, possible growth in another area could balance out that risk.
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Interest Rate Risk and High-Yield Bonds
There are pros and cons to high-yield bonds. These types of bonds — corporate bonds that were issued by companies looking to raise capital, or by “fallen angel” companies whose credit rating has dropped—might sound attractive to investors because the notion of receiving a relatively high rate of interest is appealing. But along with the high yield is the potential for a higher degree of risk.
Bonds receive ratings on their creditworthiness, with S&P Global Ratings and Moody’s serving as two of the main credit-rating agencies. Bonds with quality ratings are less likely to go into default. When a bond goes into default, interest is less likely to be paid on time, if at all, and investors may also lose their initial investment.
Bonds with high ratings include U.S. Treasury bonds and notes issued by the federal government, and those issued by large companies considered to be stable.
Bonds with lower ratings tend to need to offer higher coupon rates to entice investors. In other words, they often need to offer high-yield bonds.
When deciding whether to include high-yield bonds in their portfolio, investors may want to consider the pros and cons of doing so.
Pros of High-Yield Bonds
• Consistent yields. Bonds typically come with an agreed-upon and consistent yield, which makes the amount owed to the investor predictable as long as the company doesn’t go into default (and many don’t).
• Priority payment if the company fails. If assets of a failed company are liquidated, bondholders would be first in line for payouts, ahead of stockholders.
• Possible price appreciation. If the credit rating of the company issuing the bond improves, it’s possible that the bond’s price will go up.
• Potentially less sensitive to interest rate changes. When this is the case, it may be because high-yield bonds tend to have shorter terms than investment-grade bonds, which may be why they often have less sensitivity to fluctuations in interest rates.
Cons of High-Yield Bonds
• Higher default rates. Because of the higher risk involved, more of these bonds default. When this happens, the investor can lose all funds, including the original principal they invested.
• Harder to sell. There can be lower demand for this type of bonds, which can make it harder to sell them at a desired price (or at all).
• Possible price depreciation. If a company’s credit rating drops further, then the price can further depreciate.
• Sensitivity to interest rate changes. All bonds, including high-yield ones, are subject to interest rate risk.
The Takeaway
Bonds are a popular investment choice because they are less volatile than stocks, but they are not without risks. Interest rate risk is the potential for a bond value to drop as market interest rate rises (the opposite is also true). High-yield bonds are just as susceptible to interest rate risk as corporate or municipal bonds.
Investors can work to mitigate that risk through portfolio diversification and careful selection of bonds.
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FAQ
Why do bond prices fall when interest rates are rising?
Bond prices typically fall on secondary markets when interest rates rise because newer-issued bonds are more attractive and see higher demand.
Why are longer-maturity bonds more sensitive to interest rate risk?
When a bond has a longer maturity, i.e., five years or more, interest rates are likely to fluctuate more over that extended period. This can impact a bond’s value over time.
Is there interest rate risk if you hold onto a bond until maturity?
Yes. If an investor purchases a bond at a certain rate, and they only redeem the bond at maturity, they are locked into the interest rate of the bond. If interest rates rise, for example, the investor is losing out on potentially higher rates. If interest rates decline, however, that could spell good news for the investor.
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