Interest Rate Risk

Inflation erodes the value of fixed payments over time. But interest rate changes create an even more immediate problem: they move bond prices right now.

What Is Interest Rate Risk?

• Interest rate risk is the risk that changes in prevailing interest rates will cause the market value of a bond to change
• Bond prices and interest rates have an inverse relationship:
  • When interest rates rise, bond prices fall
  • When interest rates fall, bond prices rise
• This happens because newly issued bonds offer higher (or lower) yields, making existing bonds less (or more) attractive

Why does this happen? Imagine you own a bond paying 3%. If new bonds start paying 5%, nobody wants your 3% bond at full price. You would have to sell it at a discount. That is why rising rates push bond prices down.

Exam Tip: Gotchas

• The inverse relationship is one of the most-tested concepts on the SIE. Rates up = prices down, rates down = prices up. If a question says "interest rates increased," the correct answer involves bond prices falling.

What Makes Interest Rate Risk Worse?

Two factors increase a bond's sensitivity to interest rate changes:

• A 30-year bond will fall by a larger percentage than a 5-year bond after a 1% rate increase
• A bond paying 2% will fall by a larger percentage than a bond paying 6% (given the same maturity)
• Interest rate risk is measured as the percentage change in price. Compare bonds by percentage, not by dollars lost
• Maturity matters most. A debt portfolio's value is most stable when its maturities are short, and it swings the most when its maturities are long

Zero-Coupon Bonds: The Most Rate Risk at a Given Maturity

• At the same maturity, a zero-coupon bond has more interest rate risk than any coupon-paying bond
• It pays no periodic interest; all return comes from the discount at purchase
• Its duration equals its maturity, which is longer than the duration of a coupon bond with the same maturity
• On a long-term zero, a small change in interest rates creates a large percentage change in price
• The comparison holds only at the same maturity. A Treasury bill is also a zero-coupon security, but it matures within a year, so its price barely moves when rates change. A short zero carries far less interest rate risk than a long-term coupon bond

Duration (Conceptual)

• Duration measures a bond's price sensitivity to interest rate changes
• Higher duration = more price volatility when rates change
• A zero-coupon bond has the highest duration possible at its maturity (duration equals maturity) because there are no intermediate cash flows to shorten the weighted average
• High-coupon bonds have shorter duration: their large periodic payments return more of the bond's value early, pulling the weighted average receipt of cash forward in time and reducing price sensitivity

Think of it this way: Duration answers the question "how much will the price move if rates change by 1%?" A bond with a duration of 7 will drop roughly 7% in price if rates rise by 1%.

Exam Tip: Gotchas

• Zero-coupon bonds have MORE interest rate risk than coupon bonds of the same maturity, not less. Students sometimes assume "no coupon payments = less to lose," but it is the opposite: with no cash flow before maturity, a zero is the most rate-sensitive bond at its maturity.
• Maturity still dominates. Longer maturity + lower coupon = greater sensitivity, so a 30-year zero-coupon bond swings far more than a 30-year coupon bond. A short zero, such as a Treasury bill, has very little interest rate risk.

Interest rate risk hurts when rates rise. But there is a mirror-image risk that hurts when rates fall: reinvestment risk.

What Should You Check on Exam Day?

• Can you explain the inverse relationship between interest rates and bond prices?
• Do you know why longer maturity and lower coupons increase interest rate risk?
• Can you state why a zero-coupon bond carries more interest rate risk than a coupon bond of the same maturity, and why short maturities keep a portfolio's value most stable?
• Do you know what duration measures and how it relates to price sensitivity?