Interest-Rate Risk

Interest-rate risk is the exposure of a fixed-income portfolio to losses (or gains) from movements in interest rates. When interest rates rise, existing bond prices fall because new bonds offer higher coupons; when rates fall, existing bonds become more valuable. This inverse relationship is the defining characteristic of interest-rate risk.

Why bond prices and interest rates move oppositely

A bond is a promise to pay a fixed coupon and principal on set dates. If you buy a 10-year bond with a 3% coupon, you will receive 3% of the face value every year until maturity.

Now suppose new bonds issue with a 5% coupon. Your bond is worth less, because it pays only 3%. If you want to sell it before maturity, you must discount the price to make it competitive with the new 5% bonds. The price falls.

Conversely, if rates drop to 1%, your 3% bond becomes attractive. Buyers will pay a premium to get your higher coupon. The price rises.

This inverse relationship between rates and bond prices is inexorable: higher yields require lower prices to equate the total return.

How duration measures interest-rate risk

Duration measures the sensitivity of a bond’s price to changes in interest rates. It is expressed in years and captures the average time you wait to receive the bond’s cash flows.

A bond with a 2-year duration will lose roughly 2% in price for every 1% rise in interest rates. A bond with a 10-year duration will lose roughly 10% for a 1% rate rise.

This is why long-duration bonds carry more interest-rate risk than short-duration bonds. A 30-year Treasury might have a duration of 20 years; a 2-year Treasury might have a duration of 1.9 years. In a 1% rate increase, the 30-year loses 20%, the 2-year loses 1.9%.

Duration is not the same as maturity. A high-coupon bond has lower duration than a low-coupon bond of the same maturity (because you receive cash flows earlier, reducing the average time until you get your money). A floating-rate bond, where the coupon resets with rates, has a very short duration, even if it has years of maturity.

The impact across different bond portfolios

Treasuries. A portfolio of long-term US Treasuries carries substantial interest-rate risk. A 1% rate rise can cause a 15% loss. A portfolio of short-term Treasuries carries little: a 1% rise might cause a 1% loss.

Corporate bonds. Have the same interest-rate risk as Treasuries of comparable maturity, plus credit-risk.

Mortgages. Have interest-rate risk, but it is complicated by prepayment-risk. When rates fall, homeowners refinance, and your high-coupon mortgage is prepaid; you lose the upside. When rates rise, homeowners hold their mortgages, and you are locked into a low coupon; this is extension-risk.

Managing interest-rate risk

For an investor who does not want interest-rate risk, the main strategies are:

• Shorten duration. Hold short-term bonds, which are less sensitive to rate changes. The trade-off is lower yield.

• Floating-rate notes. These bonds have coupons that reset with interest rates. Your income rises if rates rise, and the principal value is stable. But yields are low.

• Ladder bonds by maturity. Hold a mix of bonds maturing in 1, 3, 5, 7, and 10 years. If rates rise, the short-term bonds mature and can be reinvested at higher rates. Long-term bonds lose value, but only temporarily (if held to maturity, they return par).

• Hedge with derivatives. Use interest-rate swaps or futures to lock in rates or reduce duration, offloading interest-rate risk to counterparties who take the opposite bet.

For investors with a long-term horizon who are not taking withdrawals soon, interest-rate risk is less urgent. If you buy a bond and hold it to maturity, rate changes do not matter; you receive your promised coupons and principal. But if you need to sell before maturity, or if you are a fund manager marking holdings to market, interest-rate risk is real.

See also