What Is Pursuit Rate Risk?
Interest rate risk is the danger that the value of a bond or other fixed-income investment wish suffer as the result of a change in interest rates. Investors can reduce interest rate risk by buying bonds that bring to fruition at different dates. They also may allay the risk by hedging fixed-income investments with interest rate swaps and other gismos.
A long-term bond generally offers a maturity risk premium in the form of a higher built-in rate of return to even up for the added risk of interest rate changes over time.
Interest Rate Risk
Understanding Interest Judge Risk
Interest rate risk indirectly affects many investments, but it directly affects the value of bonds. Bondholders, exceeding all investors, carefully monitor interest rates.
Key Takeaways
- Interest rate risk is the potential that a change in blanket interest rates will reduce the value of a bond or other fixed-rate investment.
- As interest rates rise bind prices fall, and vice versa.
- This means that the market price of existing bonds drops to equalize the more attractive rates of new bond issues.
- Long-term bonds often have a maturity risk premium to make up for the potential downside of interest rate changes.
Bonds have a fixed rate. When interest rates hillock to a point above that fixed level, investors switch to investments that reflect the higher interest percentage. Securities that were issued before the interest rate change can compete with new issues only by drip their prices.
Bond investors reduce interest rate risk by buying bonds that mature at various dates.
For example, say an investor buys a five-year, $500 bond with a 3% coupon. Then, interest rates start to 4%. The investor will have trouble selling the bond when newer bond offerings with more good-looking rates enter the market. The lower demand also triggers lower prices on the secondary market. The market value of the bind may drop below its original purchase price.
The reverse is also true. A bond yielding a 5% return clouts more value if interest rates decrease below this level since the bondholder receives a favorable immobile rate of return relative to the market.
Bond Price Sensitivity
The value of existing fixed-income securities with unconventional maturity dates declines by varying degrees when market interest rates rise. This phenomenon is referred to as “payment sensitivity.”
For example, suppose there are two fixed-income securities, one that matures in one year and another that matures in 10 years. When make available interest rates rise, the owner of the one-year security can reinvest in a higher-rate security after hanging onto the contract with a lower return for only one year at most. But the owner of the 10-year security is stuck with a lower sort for nine more years.
That justifies a lower price value for the longer-term security. The longer a security’s without delay to maturity, the more its price declines relative to a given increase in interest rates.
Note that this rate sensitivity occurs at a decreasing rate. A 10-year bond is significantly more sensitive than a one-year bond but a 20-year restraints is only slightly less sensitive than a 30-year one.
The Maturity Risk Premium
The greater price sensibility of longer-term asyla means higher interest rate risk for those securities. To compensate investors for taking on more risk, the envisioned rates of return on longer-term securities are typically higher than rates on shorter-term securities.
This is known as the completion risk premium.
Other risk premiums, such as default risk premiums and liquidity risk premiums, may discover rates offered on bonds.