What is interest rate risk?

Interest rates and bond prices move in opposite directions

The key principle of bond investing is that interest rates and bond prices always move in opposite directions. When interest rates rise, fixed rate bond prices fall.

According to the Securities and Exchange Commission (SEC), interest rate risk accompanies all bonds, including government bonds.

Long-term bonds are more risky because the longer the maturity, the greater the likelihood that interest rates will rise, which will cause bond prices to fall. This is why it is recommended to hold a diversified range of bonds with different maturity dates.

On the other hand, bonds generally pay a fixed dividend or coupon until maturity. When interest rates in the market rise, your fixed coupons become less profitable because you could get a higher interest rate elsewhere. If only a few coupons remain to be paid, the cumulative effect of this drop in profitability is less significant than when the maturity date is further away.

Bond issuers strive to make long-term bond coupons as attractive as possible to offset the negative impact of interest rate increases. However, sophisticated investors seek to further limit interest rate risk by holding a range of short, medium and long-term bonds.

As already mentioned, short-term bonds are less likely to be devalued due to interest rate risk, because there is less time for multiple interest rate hikes to occur, and because ‘they pay fewer coupons, which mitigates the cumulative effect of a possible decline in coupon profitability.

Because of this relationship, traders and investors should be particularly mindful of interest rate risk when buying bonds.

There are two types of bonds: government bonds and corporate bonds.

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