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Changing interest rates directly affect fixed-income investments such as bonds.
They have an inverse relationship — bonds tend to lose value when interest rates rise.
The duration or maturity of a bond is the time it has to be held to receive its full value with interest.
Bonds of longer duration face greater interest rate risk than short-term ones.
Bond funds offer easy and affordable diversification that can reduce interest rate risk in your portfolio.
What is interest rate risk?
All investments come with a certain amount of risk, but fixed-income securities such as government and corporate bonds are generally less volatile than stocks. And although they may carry less risk than stocks, bonds are still subject to losses in value. For example, when interest rates rise above the rate locked in at the time of purchase, the bond's price falls. This is known as interest rate risk.
The recent collapse of Silicon Valley Bank offers a real-world example of interest rate risk. When interest rates were low, the bank moved tens of billions of dollars into long-term bonds. But when the Federal Reserve raised rates over the course of 2022, newly issued bonds had higher yields than the bonds SVB was holding, causing the value of SVB's bonds to plummet.
This was a clear reminder that while Treasury securities are often billed as "risk free," that's only the case when they're held to maturity.
In investing, your risk tolerance describes your ability to withstand losses when investments perform poorly. Usually, the higher the risk, the higher the potential return and loss, especially with stocks.
If you compare the risks and rewards of equities to bonds, the stock market is the place people typically go to grow their assets, says Chris Burns, a certified financial planner and assistant director of research at Greenleaf Trust. Burns, based in Kalamazoo, Michigan, says the risk you take investing in equities is "trading your savings today, for a growing pile of corporate earnings" as a shareholder. But, things can go south if the companies you've invested in earn less than planned.
» Learn more about your risk tolerance: What it is and why it's important
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Interest rate risk is inherent to bonds
Lower-risk investments also can incur losses. Bonds can generate income, usually earn more modest returns, and help balance out the volatility of stocks, especially during economic uncertainty. Quality investment-grade bonds, especially those issued by the U.S. Treasury, have a low probability of default. They also legally guarantee to repay your money upon maturity. That's because, in the case of bankruptcy and liquidation, the rights of a company's lenders (bondholders) take preference over its shareholders.
But despite all that, fluctuating market interest rates can still impact the value of bonds.
Under normal market conditions, the shorter the time frame, the lower the expected return because there's less risk of interest rates changing too much. The longer the time to maturity, the greater the chance that interest rates could change, hence greater investment risk and volatility. When market interest rates rise, bond prices tend to fall, and vice versa.
Suppose you buy a bond valued at $1,000 with a 3% interest rate. A year later, a similar bond yields a 4% interest rate. With its lower interest rate, your bond pays less in the long run than the new bond, making it less valuable on the market. This will likely drive the cost of the bond down below its face value ($1,000) if you sell it before it fully matures.
But if, on the other hand, you purchase a bond and later interest rates drop, the market price of your bond will rise because you locked in a higher return before rates fell.
» Learn more: What is a bond and how do they work?
Minimize interest rate risk by diversifying
Interest rate risk is most significant for owners of bonds, especially for bonds of longer duration.
While avoiding the effects of changing interest rates altogether may not be possible, you can minimize its influence on your portfolio by diversifying.
Asset allocation involves spreading your dollars across stocks, bonds, cash or other investments based on your goals, time horizon and risk tolerance. Owning various bonds (and bonds of varying durations) reduces the risk that any one bond will have a disproportionate impact on your portfolio. You can also achieve this by investing in collections of bonds rather than single bonds, such as through bond mutual funds and exchange-traded funds (ETFs).
Funds are categorized by interest rate risk, explains Burns, so "you can specifically target the interest rate risk that you're looking to achieve in your portfolio." Concerned about rising rates, for instance? Short-duration funds are less exposed to rising interest rates, meaning their prices will fall less if interest rates rise. Or, if you think interest rates might decline, look at long-duration funds.
» Learn more about diversification: What it is and how to do it
Interest rate risk vs. credit risk — what's the difference?
Now that you know the nuances of interest rate risk, it's important to understand the impact of credit risk. Credit risk is the likelihood the bond issuer will be unable to pay you back and default.
Three agencies — Fitch Ratings, Moody's Investors Service and Standard & Poor's — rate bonds based on their ability to make interest and loan payments to investors. Bonds receive a rating between A and D, with A indicating 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.