What Is Interest Rate Risk?

Interest rate risk refers to the likelihood that an asset’s value will decline when interest rates rise. Interest rate risk primarily impacts fixed-income assets like bonds and Treasuries, as these assets’ rates factor into their prices.

Understanding interest rate risk

Fixed-income asset prices share an inverse correlation with interest rates.

When market rates rise – like when the Fed hikes rates – investors flock to newly-issued bonds that pay these higher rates. That decreases demand for bonds on the secondary market, since they carry lower comparative interest rates. To compensate investors for the loss in yield, bond prices decline.

For instance, say an investor buys a 10-year bond with a fixed interest rate of 5%. As long as market rates stay the same or decline, the bond price will stay steady, or even rise. But if the prevailing market rate jumps to 7%, the bond’s price will decline, as investors can find a better return elsewhere.

In reverse, when interest rates decline, existing bonds carry higher comparative rates. That drives up demand for bonds on the secondary market, which brings prices up, too.

Bond price sensitivity

While all bonds are susceptible to rate fluctuations, different bonds have varying levels of price sensitivity. Price sensitivity is measured by a bond’s duration, which tells investors how much its price may move if interest rates change.

Longer duration bonds are more sensitive to interest rates than shorter duration bonds. It means that for any given change in interest rates, a longer duration bond will fall or rise more than a lower duration one..

Bear in mind that this sensitivity lessens with time to maturity. For instance, 10-year bonds are significantly more price sensitive than 1-year bonds. However, 30-year bonds are only slightly more sensitive than 20-year bonds.

Maturity risk premium

Long-term bonds have higher interest rate risk than short-term bonds because they’re more likely to see rate fluctuations before maturity. To compensate, they carry a “maturity risk premium,” or higher built-in rate of return that offsets added risks.

How to reduce your interest rate risk

You can minimize interest rate risk through two basic strategies: hedging and diversification.

Hedging strategies typically involve buying assets that hedge against the probability of financial loss. (Think risky assets like interest rate swaps, futures and options.)

Diversification is the process of spreading your investment capital across an array of assets and asset classes. For bond-based portfolios, that could mean mixing short- and long-term maturities, as well as buying both government- and corporate-issued bonds.

Another diversification alternative is to add securities that are less prone to interest rate risk (like equities) to your portfolio.

What this means for you

The Fed’s post-pandemic interest rate hikes reminded investors that rate fluctuations can impact all kinds of assets – sometimes drastically. Still, bonds, Treasuries and other fixed-income securities remain the most susceptible to rate changes.

While it can be tempting to hedge against interest rate risk on your own, these strategies have their own downsides. That’s one reason Q.ai leverages the power of artificial intelligence in our Investment Kits: to tackle the hard parts of investing for you – so you can get to securing your future with greater peace of mind.

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