Interest Rate Risk
What Is Interest Rate Risk?
Interest rate risk is the possibility that changes in interest rates will affect the value of an investment, particularly bonds and other fixed-income securities. When interest rates rise or fall, the prices of certain investments may move in the opposite direction.
This risk is especially important for investors who hold bonds or interest-sensitive assets.
Why It Matters
Interest rate changes can significantly affect investment returns. Rising interest rates typically reduce the market value of existing bonds, while falling rates may increase their value.
Understanding interest rate risk helps investors make informed decisions when building diversified investment portfolios.
How Interest Rate Risk Works
Interest rate risk occurs because new bonds issued at higher interest rates make older bonds with lower rates less attractive.
Factors that influence this risk include:
- the maturity length of the bond
- prevailing market interest rates
- inflation expectations
Longer-term bonds generally experience greater price fluctuations when interest rates change.
Example
If interest rates rise from 3% to 5%, older bonds paying 3% interest may decline in value because newer bonds offer higher returns.
Interest Rate Risk vs Credit Risk
- Interest rate risk involves price changes caused by interest rate fluctuations.
- Credit risk involves the possibility that a borrower may fail to repay a loan or bond.
FAQs About Interest Rate Risk
Which investments are most affected by interest rate risk?
Bonds and fixed-income investments are particularly sensitive to interest rate changes.
Do short-term bonds have less interest rate risk?
Yes. Shorter maturities usually experience smaller price changes.
Can diversification reduce interest rate risk?
Diversifying across asset types and maturities may help manage this risk.
Related Terms
