Interest rate risk is an idea that many investors find mystifying.
Bonds pay an interest rate, or yield. It’s often fairly low but the money is typically considered safer than cash invested in stocks.
Bonds can be held until they expire (to maturity) or sold. The bond issuer pays the bond investor that yield every year until the bond matures.
But what if the investor needs cash, or wants to buy some other investment? In that case, they can sell the bond to someone else, who then collects the interest payments.
If interest rate rise, any bond that pays less than the current rate can lose value. Newer bonds with similar years to maturity might pay more, making them more attractive to buyers.
If the owner of the bond wants to sell, he or she thus would have to accept less cash to make up for the fact that other, newer bonds pay more interest.
That’s why traders say that bond prices and bond yields have an inverse relationship.
That relationship states that if yields rise, bond prices fall. That is, if interest rates rise, the market value of existing bonds that pay a lower yield goes down.
Now think of the entire equation in reverse.
Bonds appreciate in price steadily as interest rates fall over time. That’s because the older bonds pay out more in interest than do new bonds.
Once that trend reverses and interest rates start to rise, the older bonds are immediately less attractive. Demand for them declines and their prices fall.
For the long-term investor, then, interest rate risk is the risk that rates might rise and cost the investor who holds long-dated bonds.
One way to reduce interest rate risk is to own bonds that are short-term. While they pay less interest, the investor is not as locked in to the problem of falling yields.
Of course, a bond investor could just hold the long-dated bond and collect the income that’s due. But that strategy creates two new problems.
First, the money left in a long bond likely could be invested more profitably somewhere else.
This is what’s known as opportunity cost.
Second, interest rates typically rise in response to the risk of rising inflation. If the inflation rate is greater than the yield on a long bond, the income from that bond is now zero in terms of future purchasing power.
It might even go negative if inflation takes off. Imagine owning a bond paying 3% in a 5% inflation rate environment. Now imagine trying to sell that bond to someone else.
There can be bond market crashes, episodes when bond prices fall dramatically. But it’s usually stocks that experience volatile, unexpected price swings.
Interest rate risk is managed by investors through diversification and maintaining low durations, that is, low average maturities in a rising rate environment.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.