Interest rate risk is the possibility that instead of going up in value, an investment asset can go down in value due to fluctuations in interest rates. It’s a type of opportunity risk: When someone pursues one type of investment opportunity, they may be giving up the opportunity to invest in another asset.
This term is usually made in connection with bond purchases. When market interest rates go up, the prices of fixed-rate bonds go down. Conversely, lower market interest rates equal higher fixed-rate bond prices. This is an inverse relationship that goes in both directions.
How Does a Bond Work?
Bonds are a type of loan, with funds going from the investor to the issuer. The issuer could be the federal government, a state or local government, or a company. In return for the bond purchase loan, the investor is promised that they will be repaid the full amount of the bond—plus a predetermined amount of interest—on a specific date.
Traditionally, bonds have paid a fixed rate, although there are some with a variable or “floating” interest rate.
The predetermined rate is called the coupon rate, with interest paid on coupon dates. Bonds come with an expiration or “maturity” date, when the value of the bond must be paid back in full.
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 see a capital gain. If not, the sale might be made at a loss.
While there’s no such thing as a safe investment, investors typically consider bonds to be lower-risk than stocks and some other investments.
Interest Rate Risk and Timing
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 return rates, which means that the existing bonds with lower returns are in lower demand.
In general, long-term bonds come with more interest rate risk than ones with shorter terms. The more that interest rates rise after the bond was purchased, the more of an impact that has on the investor’s return on investment.
The Office of Investor Education and Advocacy of the US Securities and Exchange Commission (SEC) offers a helpful resource on this subject. In it, they provide two contrasting examples to illustrate the concept.
In the first example, they assume that a Treasury bond has a 3% interest rate. A year later, market 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 maturity yield going up.
Interest Rate Risk Management
One way to handle investment risk is with diversification. This means building an diversified portfolio that includes a variety of different asset classes, such as stocks, mutual funds, and real estate or other alternative investments, along with different types of bonds, some with staggered maturity dates. 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.
Another form of interest rate risk management is participation in hedge funds. With a hedge fund, money from multiple investors is collectively invested, with the goal of receiving a positive return on investment.
That said, because there are relatively higher fees involved with hedge funds, this is a strategy that the SEC calls “limited to wealthier investors” as well as “institutional investors, including pension funds.”
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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 the two 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 Treasury bonds 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 yield, which makes the amount owed to the investor predictable as long as the company doesn’t go into default (and many don’t). Stocks, on the other hand, don’t need to pay dividends at all and they don’t come with a guaranteed return on investment.
• Priority payment if the company fails. If assets of a failed company will be liquidated, bondholders would be first in line for payouts, ahead of stockholders.
• Possible price appreciation. If the credit rating score of the company issuing the bond improves, it’s possible that the bond’s price will go up. This isn’t possible for AAA bonds from companies with good credit ratings.
• 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.
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 some may choose to look into hedge fund investing.
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