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Interest Rate Risk

Bonds

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Interest rate risk is the possibility that interest rates will increase. This occurs when a central bank with jurisdiction over the currency of your bond’s issue raises rates. The price of a bond moves in opposition to the interest rate. If you are holding a fixed rate bond and the central bank moves the interest rate downward, your bond’s market value will increase. If you have a bond at the current rate and the central bank moves the interest rate upward, your bond’s market value will decrease.

When interest rates rise, your first option is to immediately sell your bond for the reduced price. You can purchase bonds which pay the higher rates with your sales proceeds. Your other option is to hold the bond. You would lose the potential future interest you’d receive if you reinvested the money at higher interest rates post sale. You won’t suffer the immediate decrease in value from the sale.

You should note that the market prices of bonds move, but the payments of interest or maturities will not be affected. If you hold onto your bonds, you will receive the same interest and maturity payment. If rates rise, you will lose potential profit by holding the bond. The value of actual payments will not decrease.

Long term bonds are strongly affected by these changes, since their interest payments last for longer periods. Investors desire to be locked into bonds above market rates for the long term, and avoid long term below market rates. The price of long term bonds move farther in relation to interest rates than short term bonds.

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