What is interest rate risk?
Interest rate level risk is the possibility that an interest-bearing asset will lose value if market interest rates rise above its coupon rate.
Key points to remember
- Rate level risk is the risk that an interest-bearing asset will lose value if market interest rates exceed its coupon rate.
- Interest rate risk is one of the main factors affecting bond prices and generally increases with duration.
- When market interest rates rise and cross the level of the coupon rate, the value of a bond decreases and the investor risks losing the value of his investment.
Understanding rate level risk
Interest rate risk is one of the four main factors affecting bond prices and generally increases with durationa measure of the price sensitivity of a fixed income investment to a change in interest rates, expressed in terms of years.
When a government or corporation issues fixed income securities, the price and coupon are set by the transmitter to be competitive in the current pricing environment. The bonds will be offered at prices based on the structure of the term and the corresponding rates through the current yield curve. As interest rates vary in the future, the prices of existing bonds will fluctuate accordingly. When interest rates rise, bond prices fall and when interest rates fall, bond prices rise.
When interest rates fall, holders of bonds and other fixed income securities will generally see the value of their equity increase, even if the coupon rate is fixed. They may be able to sell their bond for a higher price than they paid. However, when rates rise, the value of a bond or portfolio of bonds that were issued at corresponding lower rates will decline. When the rise in market interest rates exceeds the level of the coupon rate of the fixed income investment, the investor risks losing value. This will be evident in the daily pricing of bond mutual funds. For example, during a period when longer-term rates are rising, a bond portfolio that has a concentration in longer-term bonds will see its value fall.
Investors who hold individual bonds can hold their bonds until maturity (unless the bond has a call function and is called) and receive the full return that the bond originally offered, except default. This assumes that the investor is comfortable earning less than may be available in the current market. For managers of large bond portfolios, rising interest rate levels have a significant effect on the value of the portfolio and on the manager’s ability to attract and retain investors. For this reason, professional bond managers generally trade more frequently than individual bondholders in order to produce competitive prices and yields for the portfolio.
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