The risk associated with a decline in investment value due to fluctuations in prevailing interest rates is known as interest rate risk. It is the potential losses that may be incurred on investments as a direct result of changes in the interest rate. In addition to share market basics, it is important for investors to track the changes in interest rates to make informed decisions about their portfolios.
In this article, we will cover what interest rate risk is and its impact on the fixed-income investment market and understand it with examples.
What is interest rate risk?
To understand interest rate risk, let us first learn what long-term fixed-income investments are. Fixed-income investments are debt instruments that assure fixed interest returns over a designated period. Long-term fixed-income investments can protect investors against a fall in interest rates as they would guarantee returns at the agreed-upon rate. However, interest rate risk comes into the picture when the opposite happens.
Suppose that interest rates in the market have increased. This means that the fixed-income investment may now offer lower returns compared to other investments in the market. One of the most popular fixed-income investments is bonds, and changes in interest rates affect all types of bonds. A rise in interest rates makes already issued older bonds a less attractive option and causes the price of these bonds in the secondary market to fall.
A time-tested method to mitigate interest rate risk is having a diverse portfolio of bonds with different maturity periods. Diversified bond maturities ensure that even if a bond investment in your portfolio is affected by the changes in interest rates, you can cut your losses in a short duration and still draw net positive value. Other popular methods to manage interest rate risk include opting for future and forward contracts, options, or interest rate swap agreements.
Interest rate risk and bonds
Even though fluctuations in interest rates have the potential to impact different types of investments, they directly affect fixed-income instruments. Thus, investors in the bond market keep a close tab on the prevailing interest rates, as they directly influence their buying and selling decisions.
Fixed-income securities and the rate of interest are inversely related. When the rate of interest rises, the prices of bonds come down and vice-versa. It can be simply understood through the lens of opportunity cost. When the interest rate in the market rises, the cost of missing out on a more lucrative investment for a bondholder increases.
Example of interest rate risk
Let us look at an example. Assume that you hold a bond at Rs. 1 lakh with a rate of 5% return. This bond has a maturity of 3 years. You bought the bond as the prevailing market interest rate was 4%. However, after 1.5 years, the market interest rate increased to 6%. Suddenly, the bond becomes a less profitable investment as there are still 1.5 years to go before maturity. To make up for the lesser interest, the price of the bond falls in the secondary market.
You might notice in this example that one of the key factors in assessing the risk and loss is the maturity of bonds. For example, you would have had less to lose if the bond matured after 2 years. It would then enable the purchase of new bonds at the increased interest rate. Thus, diversification in the fixed-income investment portfolio is an effective way to mitigate interest rate risk.
Also read: Who can buy bonds
While we have primarily discussed the increase in interest rates so far, a fall in interest rates would have the exact opposite effect on bonds. It would increase their value as investments in the market and also increase their prices in the secondary market.
Price sensitivity in bonds
With looming interest rate risk, existing bonds and other fixed-income securities with different maturity dates have differing value changes. The ‘price sensitivity’ of bonds is primarily rooted in their duration. Going back to the example above, a bond with a maturity closer to the interest rate hike would be less price-sensitive compared to a bond that still has several years remaining to mature. The bond with a longer maturity period after interest rate rise may experience a steeper fall in value.
A key element to note here is that even though the price sensitivity increases in bonds as the maturity periods increase, this increase happens at a declining rate. This means that even though a 10-year bond will be significantly more price-sensitive than a 3-year bond, the price sensitivity in a 15-year bond will only be slightly less than a 25-year bond.
Also read: Convertible bond
Conclusion
Interest rate risk poses a significant threat to fixed-income investments, like bonds, due to their inverse relationship with prevailing interest rates. As discussed, when interest rates rise, bond prices fall, and vice versa, impacting the profitability of bond holdings. Mitigating this risk involves strategies such as diversifying bond maturities within a portfolio and utilising financial instruments like futures contracts or options. Understanding the dynamics of price sensitivity in bonds relative to their maturity periods is crucial for investors to make informed decisions and effectively manage their exposure to interest rate fluctuations. Overall, navigating interest rate risk requires caution, strategic planning, and a thorough comprehension of market dynamics to safeguard investment portfolios against potential losses.
