Bonds and other fixed-income assets are vulnerable to interest rate risk if interest rates rise or fall. This occurs as a result of shifts in the market, most notably a decrease in their interest rates. Many different types of investments are vulnerable to this danger, but fixed-income securities like bonds and certificates are particularly vulnerable. Let us take an overview about what is interest rate risk with examples in this topic.
The value of a bond or certificate typically decreases when the interest rate on it rises. Increases in both interest rate and opportunity cost are experienced. The opportunity cost is the sum lost because alternative investments were not pursued. Risk associated with interest rates drives it.
What is Interest Rate Risk?
Investments can suffer losses due to fluctuations in interest rates. The possibility of fluctuating interest rates is refer to as interest rate risk. A bond or other fixed-income investment will lose value if interest rates rise, for instance. The longevity of a bond is its sensitivity in price to changes in interest rates.
Bonds of varying maturities can mitigate interest rate risk, while interest rate swaps, options, and other interest rate derivatives can shield fixed-income investments from interest rate fluctuations.
Understanding of Interest Rate Risk
The value of bonds and other fixed-income instruments are particularly sensitive to changes in interest rates, while they can affect the value of other investments. Investors in bonds, therefore, constantly monitor interest rates and make choices based on their expectations for future interest rate movements.
The value of fixed-income securities decreases when interest rates rise (and vice versa). This is because it becomes more expensive to hold on to bonds when interest rates rise, as doing so means forgoing a superior investment opportunity. Bond yields thus lose some of their allure as interest rates climb. When interest rates and bond prices are both at 7%, a $1,000 bond yielding 7% would be a good investment.
However, if interest rates were to climb to 8% or 9%, that same bond would be worth much less. As a result of this market disadvantage, the value of these bonds must fall. No one will want to purchase a bond paying only 7% interest if another bond is available paying 9%. You can also read about index funds as an example to understand the topic.
Because of this, when interest rates climb above the rate at which bonds with a fixed rate can be purchased, investors typically seek for other investments. Securities issued prior to the interest rate adjustment can only compete with new issuance by decreasing in price.
Hedging and diversification methods can be use to mitigate interest rate risk by shortening a portfolio’s effective duration or offsetting the impact of rate changes. For additional information about how to deal with the possibility of fluctuating interest rates, read the article Managing Interest Rate Risk.
Interest Rate Risk Example
Consider the scenario where a buyer spends $500 on a bond with a coupon of 3% and a duration of 5 years. Soon after, the interest rate will increase to 4%. Investors may find it challenging to unload their existing bond holdings when new bonds with superior yields enter the market.
As demand decreases, secondary market prices fall as well. The bond’s market value can drop below the purchase price. There is also an inverse truth to this statement. Bonds paying 5% interest are more valuable when interest rates are low. Because bondholders receive a rate of return that is guarantee to be higher than the market rate.
Let’s take a look at a different scenario to better understand interest rate risk. So, Mr. ABC invests $10,000 in bonds at Rs. 100 apiece. These securities have a guaranteed annual return of 5%. It’s possible to earn a return of $10,500 in just one year from now if you put that money into the market. This investment would yield $10,600 after a year if the interest rate on freshly issued securities is 6% per year.
Frequently Asked Questions (FAQ)
What are the Types of Interest Rate Risk?
Every investor, whether an individual or a corporation, needs to be aware of the myriad of interest rate risk they may face. Types of interest rate risk are reinvestment risk, length of loan terms, price risk, foreign exchange rates, credit risk, market fluctuation and more.
Which Investors are Most Affected by Interest Rate Fluctuations?
Since the interest rate of a security is inversely connected to its value, investors who primarily buy bonds and certificates are most affected by interest rate concerns.
How do Fluctuating Interest Rates Impact Stock Investors?
However, stock market investors rarely feel the effects of interest rate threats. Although interest rates don’t have an immediate effect on stock prices, they can have a knock-on effect if they have an effect on a company’s financial stability.
Interest rates on floating rate bonds fluctuate with market conditions, as the name suggests. The returns on these assets rise and fall with the market, making them a solid investment choice. Long-term and short-term investments should be made in these as well. Even though this won’t always allow you to calculate your exact return, it can assist mitigate interest rate risk.
Interest rate concerns can have a significant impact on a business or an investor. So it’s important for them to consider the aforementioned risk management strategies. An interest rate risk example is use to illustrate the need for risk management to prevent a decline in the value of an investment asset.