What is Interest Rate Risk?
Interest rate risk is the chance that an unexpected change in interest rates will negatively affect the value of an investment.
How Does Interest Rate Risk Work?
Let's assume you purchase a bond from Company XYZ. Because bond prices typically fall when interest rates rise, an unexpected increase in interest rates means that your investment could suddenly lose value. If you expect to sell the bond before it matures, this could mean you end up selling the bond for less than you paid for it (a capital loss). Of course, the magnitude of change in the bond price is also affected by the maturity, coupon rate, its ability to be called, and other characteristics of the bond.
One common way to measure a bond's interest rate risk is to calculate its duration.
Why Does Interest Rate Risk Matter?
In general, short-term bonds carry less interest rate risk; less responsive to unexpected interest rate changes than long-term bonds are. This implies that short-term bonds carry less interest rate risk than long-term bonds, and some financial theorists cite this as support for a popular hypothesis that the higher yields of long-term bonds include a premium for interest rate risk.
It is interesting to note that bond investors who intend to hold their bonds to maturity are less exposed to interest rate risk for two reasons. First, these investors are not interested in interim price movements because they intend to hold the bond until it matures. Second, the amount of principal the investor receives at maturity is unaffected by changes in interest rates. However, the buy-and-hold bond investor is still exposed to the risk that interest rates will rise above the bond's coupon rate, therefore leaving the investor "stuck" with below-market coupon payments.
Interest rate risk accounts for approximately 90% of the risk involved with fixed income investing, according to research by BARRA International. Although analysts and investors spend countless hours analyzing interest rate trends and making forecasts, there is no way to tell for sure what rates will be tomorrow.