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 lose more value from a 1% rate increase than a 5-year bond
• A bond paying 2% will lose more value than a bond paying 6% (given the same maturity)

Zero-Coupon Bonds: Maximum Interest Rate Risk

• Zero-coupon bonds have the highest interest rate risk of any bond type
• They pay no periodic interest; all return comes from the discount at purchase
• Their duration equals their maturity (the longest possible duration for any bond)
• A small change in interest rates creates a large percentage change in price

Duration (Conceptual)

• Duration measures a bond's price sensitivity to interest rate changes
• Higher duration = more price volatility when rates change
• Zero-coupon bonds have the highest duration (equal to maturity) because there are no intermediate cash flows to shorten the weighted average

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 the MOST interest rate risk, not the least. Students sometimes assume "no coupon payments = less to lose," but it is the opposite: no cash flow means maximum sensitivity to rate changes.
• Longer maturity + lower coupon = greater sensitivity. A 30-year zero-coupon bond is the most rate-sensitive bond you can hold.

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