Interest Rate Risk

Interest rate risk is the potential for losses in the market value of bonds and other fixed-income securities caused by changes in prevailing interest rates. When market rates rise, existing bonds with lower coupon rates become less attractive and their prices fall; when rates fall, existing bonds with higher coupons gain value.

Key takeaways

• Bond prices and interest rates move inversely: as rates rise, bond prices fall, and vice versa.
• Interest rate sensitivity is measured by duration; longer-duration securities are more sensitive to rate changes.
• Investors can reduce interest rate risk by diversifying maturities or using interest-rate hedges (swaps, options, futures).

How interest rate risk works

Fixed-income securities pay a fixed stream of cash flows. If new issues offer higher yields, the fixed payments on older bonds are relatively less attractive. To compete, the market price of older bonds adjusts downward so their effective yield aligns with current rates.

Duration is the primary measure of this sensitivity. Roughly speaking, a bond’s duration estimates the percentage change in price for a 1% change in interest rates. Longer time to maturity and lower coupon rates generally increase duration and therefore price sensitivity.

Example

An investor buys a five-year bond for $500 with a 3% coupon. If market interest rates rise to 4%, newer bonds will offer higher yields, reducing demand for the 3% bond. The bond’s market price will drop until its yield matches the prevailing rate. Conversely, if rates fall below 3%, the bond’s market value would rise because its fixed coupon is now favorable relative to new issues.

Bond price sensitivity and maturity

Price sensitivity varies by maturity:
* Short-term bonds: lower duration and less price sensitivity because investors can reinvest at new rates sooner.
* Long-term bonds: higher duration and greater sensitivity because their lower coupon payments persist longer.
Sensitivity increases with maturity but at a decreasing rate (for example, a 10-year bond is more sensitive than a 1-year bond; a 30-year bond is only moderately more sensitive than a 20-year bond). Convexity further refines how price changes behave for large interest-rate moves.

The maturity risk premium and other premiums

Longer-term bonds typically offer higher yields to compensate investors for greater interest rate risk. This additional expected return is called the maturity risk premium. Bond yields may also reflect other premiums, such as default risk and liquidity risk.

Managing interest rate risk

Common approaches to reduce or manage interest rate risk include:
* Diversifying maturities (laddering) to reduce portfolio duration.
Shortening average duration by favoring shorter-term bonds or higher-coupon issues.
Hedging with interest-rate derivatives (swaps, futures, options) to offset expected rate moves.
* Holding bonds to maturity to avoid realizing market-price fluctuations, recognizing that reinvestment risk remains.

Conclusion

Interest rate risk is a central consideration for fixed-income investors. Understanding duration and how maturity, coupon, and market conditions affect price sensitivity helps investors choose suitable bonds and adopt strategies—diversification or hedging—to manage the impact of changing interest rates.