Interest rate risk refers to changes in interest rates that could affect the market value of your bond or other fixed-income investments. This is a real concern for investors in any economic climate but is especially concerning during periods of rising interest rates. Interest rate risk, maturity risk and liquidity risk are among the risks investors in bonds and other fixed-income assets must keep in mind. Working with a financial advisor can help protect your assets from unnecessary risks that you may encounter when investing on your own.
Interest Rate Risks Explained
Interest rate risks are the risks that the prices of fixed-income securities, such as bonds, will decline when interest rates rise. This is due to the opportunity cost of missing a more favorable investment. The inverse is also true – bond prices may increase when interest rates fall.
Bond prices may fall when interest rates rise because it could make existing bonds less attractive. For example, if you buy a bond with a 3% yield and interest rates rise to 4%, your 3% bond is less favorable to investors. Because they can buy new bonds with a 4% yield, the price of your bond must fall to make up for the lower yield.
This risk of falling prices is also known as a market risk because it would affect you when selling bonds on the secondary market. Thus, this does not apply to bonds that can’t be sold on the secondary market, such as U.S. savings bonds.
Maturity risk, or duration risk, is closely related to interest rate risk. Bonds with a longer term carry more risk because there is a longer period during which interest rates may rise. Thus, there is a greater chance that bonds with a longer term may see their price eroded at some point.
For example, imagine you are comparing three bonds: one with a three-month term, one with a one-year term and one with a 10-year term. The chances that interest rates will increase before the three-month bond expires are relatively low. However, the odds that interest rates will rise in the next 10 years are much greater.
To compensate for the increased risk, the yield on the 10-year bond will be higher than the yield on the three-month bond. The yields on bonds increase consistently up to the bonds with the longest terms, which is typically 30 years.
Liquidity and Inflation Risks
Those investing in bonds and other fixed-income securities face other risks, such as those around liquidity and inflation. Liquidity risk is the risk that you will have difficulty finding a buyer when attempting to sell a bond. You can assess liquidity risk by checking the trading activity of bonds before buying them. If the bond has a high daily trading volume, the liquidity risk is likely to be low and vice versa.
Inflation risk for bonds is much the same as inflation risk for cash. If inflation rises faster than the bond’s yield, then the bond’s purchasing power will decline over time. This means that periods of high inflation can make bonds a less attractive investment than other assets.
How to Address Risk
While every investment comes with a certain level of risk, it is possible to hedge your investment to reduce the risk that interest rates or inflation will derail your investment strategy. As many investors know, diversification is often one of the best tools available, and that applies here, too.
For example, you can invest in bonds with different terms. Bonds with longer terms will have higher yields, but they also carry more risk. Meanwhile, those with short yields have relatively low risk, but also low yields. Thus, spreading your investment across different terms can help you achieve an acceptable yield while reducing your portfolio’s level of risk.
Bond investors also have other tools available to hedge their interest rate risks. For example, some investors may consider derivatives such as futures and options. However, derivatives are advanced strategies typically reserved for sophisticated or professional traders.
Bonds and other fixed-income assets provide investors with reliable income while keeping risks relatively low. However, that does not mean that these investments are without risk. Interest rate risk, maturity risk and inflation risk are among the ways in which bonds can be devalued over time. Bond investors who want to reduce their risk level may consider strategies such as buying bonds with several different terms.
Tips for Investing
- It’s not always easy to know how interest rate risk will affect your portfolio. A financial advisor can help you develop an investment strategy that works for you. And finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Unsure how much your investments will grow over time? Try SmartAsset’s free retirement calculator to estimate how much you need from each investment type to hit your long-term goals.
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