Arvest Education Center
Interest Rate Risk
The changing interest rate environment has prompted many individuals to examine their borrowing and take advantage of lower rates. The effect of the current lower rates also has been felt as individuals invest in or renew CDs. Lower borrowing rates have been coupled with lower rates being paid on savings accounts and CDs. Borrowers have been happy while savers have been less happy.
What is interest rate risk?
One lesser-understood effect of changing interest rates is how changing rates cause the value of fixed income investments to rise or fall. This is called interest rate risk. When interest rates rise, the values of fixed income investments, like bonds, fall. Conversely, when interest rates fall, the values of bonds rise.
This happens because the values of bonds are determined in the marketplace. There are thousands of traders and investors constantly buying and selling bonds. The prices at which they will buy and sell are based on the existing interest rate environment.
The amount by which the values rise or fall is primarily dependent on the maturity of the bond. The longer the maturity a bond has, the greater its value changes when interest rates change. For short-term bonds, like 90-day Treasury Bills, the impact of changing rates is very small.
For a 30-year Treasury Bond, a 1 percent rise in the interest rate can result in as much as a 12 percent drop in value. A 2 percent rise in rates can result in a fall of 22 percent in value. If interest rates fall, the values of bonds will rise, but not quite by the same percentages (because of the way the present value calculations work).
If you include bonds (or other fixed income investments) in your portfolio, you should understand their values can fluctuate with changes in interest rates.
How should you consider interest rate risk in your investment strategy?
- Understand long-term bonds can and do rise and fall in value.
- If you expect to need funds you want to dedicate to fixed income investments, keep the maturities short so unexpected changes in interest rates do not have as much of an affect. For example, for very short-term needs, a 90-day Treasury Bill may be attractive.
- If you buy Certificates of Deposit, you can avoid the fluctuation, but may be subject to losing some interest if you redeem them before their maturity.
- The market forces causing fluctuations in bond values also affect fixed income mutual funds. The portfolio manager may try to mitigate the risks with different hedging strategies, but the value of these types of mutual funds does rise and fall. When investigating fixed income mutual funds, consider the average maturity of the portfolio and be cautious of claims that hedging strategies can eliminate interest rate risk.
Interest rate risk is just another factor to consider when building your portfolio. Staying with shorter-term bonds can reduce this risk, but it should be considered just like the quality of the institution issuing the bonds.
This content has been provided by Financial Wisdom and is intended to serve as a general guideline.