Interest Rate Risk: Definition and Examples

What is interest rate risk?

Interest rate risk is the risk that market interest rates will rise, causing a bond to become less valuable than competing bonds with higher coupon rates. Bond prices and interest rates have an inverse relationship, meaning that when interest rates rise, bond prices tend to fall.

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Which investments have interest rate risk?

Fixed-income securities such as Treasury bonds and corporate bonds are common bearers of interest rate risk, as are other types of debt instruments.

Bonds can generate income and returns, and they can help balance out the volatility of stocks in a portfolio, especially during times of economic uncertainty. In addition, quality investment-grade bonds, especially those issued by the U.S. Treasury, have a low probability of default. However, fluctuating market interest rates can affect the value of bonds in a portfolio. If market interest rates rise, the value of the bond may fall.

• Under normal market conditions, the shorter the bond’s time to maturity, the lower the interest rate risk. (There's less time available for rates to change.) Accordingly, the lower risk typically also means lower returns.

• The longer the time to maturity, the higher the interest rate risk. (There's a greater the chance that interest rates could change.) In turn, longer-maturity bonds may generate higher returns than shorter-maturity bonds. 

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Example of interest rate risk

For example, suppose you buy a bond for $1,000 and it has a 3% coupon rate. A year later, a similar issuer offers a bond with a 4% coupon. Because your bond generates relatively less income than the other bond, your bond becomes less valuable.

If, on the other hand, you purchase the bond and then coupon rates on other bonds drop, the market price of your bond may rise because it has become relatively more valuable to investors.

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How to minimize interest rate risk

While avoiding all of the effects of changing interest rates may not be possible, you may be able to minimize its influence on your portfolio by diversifying.

• Diversification involves spreading your dollars across different asset classes, such as stocks, bonds, cash or other investments based on your goals, time horizon and risk tolerance.

• Owning different kinds of bonds is another way to reduce the risk that any one bond will have a disproportionate impact on your portfolio.

• You can also diversify by investing in pools of bonds rather than single bonds, such as through bond mutual funds and exchange-traded funds (ETFs).

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Interest rate risk vs. credit risk

The main difference between interest rate and credit risk is that macro factors typically drive credit risk and fundamental factors typically drive credit risk. Credit risk is the likelihood the bond issuer will default, meaning that it will become unable to make the required interest and principal payments on the debt.

Three agencies — Fitch Ratings, Moody's and Standard & Poor's — estimate bond issuers' probability of default.

• Bonds receive a rating between A and D.

• An A rating indicates the highest investment grade, and multiple letters, such as AA, indicating a higher rating. For instance, Fitch rates investment-grade bonds from AAA to BBB.

• Risky, high-yield bonds, sometimes called "junk bonds," receive a lower rating between B to D and are labeled speculative.

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