Interest Rates

What Is Interest Rate Risk?

Interest rate risk is a form of financial risk that arises for bond owners from fluctuations in interest rates. When interest rates rise, bond prices tend to fall, and vice versa. This inverse relationship is crucial to understanding the concept of interest rate risk.

Here's why this happens:

When interest rates increase, newly issued bonds come to the market with these higher rates. Therefore, existing bonds with lower rates become less attractive. To make these older, lower-yielding bonds competitive in the market, the price of these bonds must drop to provide the same yield-to-maturity (YTM) that the newly issued bonds do.

For instance, if you hold a bond that pays a 3% coupon and new bonds are being issued at 4%, investors would rather buy the new bonds. To sell your bond, you would have to lower its price until it effectively pays a 4% yield. This is why bond prices fall when interest rates rise.

Regarding the second part of your statement, "Longer maturities have higher interest rate risk," this is due to the longer time frame for the potential of rate changes. With a longer maturity, there's a greater likelihood that rates will change (and particularly, rise) during the bond's lifetime. Therefore, all else being equal, a bond with a longer maturity will have more interest rate risk than a bond with a shorter maturity.

Additionally, when a bond has a longer maturity, an investor must wait longer to be repaid the bond's face value. During this time, the higher-yielding new bonds will erode the price of the older bond. Consequently, long-term bonds are more exposed to interest rate risk.

In the context of an investment, understanding interest rate risk is important because it directly affects the return on your investment and, therefore, your investment decisions. For example, if you believe interest rates are going to rise, you might avoid investing in long-term bonds due to the higher interest rate risk. Conversely, if you think interest rates will fall, long-term bonds might be attractive due to the potential for price increases.