Understanding Interest Rate Risks

Interest rate risk is inherent in fixed income investing: Learn the ins and outs before you jump in.

“Bond prices go down when interest rates go up”. That’s the oft-repeated maxim in fixed-income investing, and mathematically, all else equal, it’s true. But prices for some bonds fall more than others given the exact same change in interest rates. Understanding the basic drivers of interest-rate risk can help you identify which bonds make the most sense for you, and can help you identify which bonds are best to own—or best to avoid—if you think interest rates will increase.

In general, bond values decrease when interest rates increase because investors can get a better deal in a rising-rate environment. Imagine a bond that’s fairly priced and paying a 4% coupon. That coupon—another word for the regular interest payment—is typically a fixed cash amount, say, 4% of a 100 pound par bond, or 4 pounds. If interest rates suddenly increase, a newly issued bond that’s very similar to the original bond might carry a 5% coupon, paying 5 pounds annually. Given the choice, who would wish to own the 4% coupon bond? Well, no one, if the price remained 100 pounds. Instead, the market value or price of the 4% coupon bond would decrease to make it comparable to the yield of the 5% bond. If you own the 4% bond, you still receive your 4 pounds per year, but the bond’s market value in your portfolio—the price you’d get if you sold it today—decreases.

But even “similar” bonds aren’t identical, and different bonds will react very differently to the same movement in rates. Fortunately, the building blocks of interest-rate risk are fairly intuitive to grasp, starting with maturity. All else equal, a 10-year bond carries more interest-rate risk than a 5-year bond, for example. This makes sense because your money is subject to the risk of rising interest rates for a longer period of time. The statistic used to measure this time-weighted interest-rate risk is called “duration”. A higher time-weighted average—a higher duration—means more interest-rate risk, and clearly it will take longer for you to get paid for a 10-year bond than with a five-year bond. (For more information on duration as a measure of interest-rate risk, see Understanding Duration.)

All this means that one way to reduce interest-rate risk is to shorten up on the maturity of your bond holdings. The flip side is that shorter-term bonds (in a normal yield curve) will tend to pay less in coupon than longer-term bonds. It’s a balancing act.

Another way to tame interest-rate risk is to use bonds with higher coupon payments. The logic here is the same as above; namely, that the duration—the time-weighted average of the cash flows—will be lower for high coupon bonds, because every year, you get more cash paid to you sooner, all else equal. However, these two paths to reduced interest-rate risk seem to be in conflict: Shortening up on the maturity typically produces lower coupons, not higher coupons. To get higher coupons with shorter maturity means taking on risk elsewhere; namely, credit risk.

Therefore, short-dated high-yield bonds—bonds with lower maturity, higher coupon payments but with higher risk of default—are an attractive choice to reduce interest-rate risk. But it’s important to recognize there’s no free lunch here: Mitigating interest-rate risk while maintaining yield means trading one kind of risk for another. The important thing for investors is to make these trade-offs with eyes open, and not be lured in by promises of high yields without looking at both credit and duration.