Bonds are mistakenly considered a “safe” investment, because they usually don’t result in an investor losing his shirt. The truth is that bonds carry their own unique set of risks, and it is vital to understand each of them.
Let’s say you bought a 10-year, $1,000 bond today at a coupon rate of 5%, and interest rates rise to 7%. What you once thought was a great coupon isn’t looking so great anymore.
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Rising interest rates make new bonds more attractive because they earn a higher coupon rate. Thus, another phrase for interest rate risk is “opportunity risk”, meaning there’s a risk that a better deal will appear that you can’t take advantage of.
Thus, the longer the term of your bond, the greater the chance that a more attractive bond investment will appear, increasing your interest rate risk.
It gets worse. Let’s say you need to sell your 5% bond prior to maturity. If interest rates are higher, you now must compete with bonds paying a higher interest rate.
This will decrease demand for bonds at 5%, forcing you to sell it at below par, or even less than you paid for it. Price gets pushed down.
That’s why you may have heard that when interest rates rise, bond prices fall, and vice-versa.
The longer the duration of your bond, by the way, the more volatility it will experience in price. Any suggestion that interest rates may rise could send the price of your long-term bond down significantly. That’s yet another reason why long-term bonds earn higher interest rates – because there is more risk the bond price will decline over time.
Bond fund managers face the same risks as individual bondholders. When interest rates rise—especially when they go up sharply in a short period of time—the value of the fund’s existing bonds drops, which can put a drag on overall fund performance.
Since bond prices go up when interest rates go down, you might ask what risk, if any, do you face when rates fall?
What might move interest rates up or down? There are so many economic factors that affect the level and direction of interest rates. Historically, we see interest rates increase when the economy is growing, and decline during economic downturns. That’s because, in bad times, the government tries to induce people to borrow money by making it cheaper, so they can invest it in business.
Also, rising inflation leads to rising interest rates, and declining inflation leads to lower interest rates.
In conclusion, interest rate risk can be thought of as a combination of two events caused by a change in interest rates.
If the return the market demands on the investment is higher or lower than the bond’s interest rate, the bond’s price adjusts to offer the market’s required return. Thus, if interest rates change, bond prices also change and bond investors can gain or lose money.
About Lawrence Meyers – Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at email@example.com.