Bonds and Interest Rate Risk
Investing in Bonds Involves Understanding Associated Risks
When interest rates increase, investors face risks that their bonds' values may significantly decline. This is referred to as interest rate risk.
The price of a typical bond changes inversely to changes in interest rates or yields (*note that the two terms will be used interchangeably). In other words, when interest rates increase, bond prices fall and vice versa. Since bond prices fluctuate relative to interest rates, among other things, bond investors would be wise to incorporate interest rate risks into their portfolios’ performance measurements.
Why the Inverse Relationship between Bond Prices and Interest Rates?
This relationship is best explained through an example. Let us assume an investor has just purchased a 6% coupon 15-year bond at par (100). At that price and coupon, this hypothetical bond’s yield is also 6%.
But then, a few days after purchasing the bond, two things happen: first interest rates increase to 6.5%, and second, the investor now wants to get rid of his 6% coupon bond. Unfortunately, with interest rates now higher at 6.5%, the investor is quite unlikely to find a buyer for his 6% coupon bond who would also be willing to pay par value for it.
What is the investor to do? Well, the investor cannot make the issuer of the bond increase the coupon rate from 6% to 6.5%, nor shorten the maturity of the bond that would make it more attractive to potential buyers. All that the investor can do is to adjust the price of his bond downward to justify the yield of 6.5%, which would work out to about $94.45. Now you see the predicament our hypothetical investor could find himself in if and when interest rates increase.
Bond Features Impacting Interest Rate Risk
How sensitive a bond’s price is to interest rate fluctuations depends on certain characteristics of the bond, such as maturity, coupon rate and existence of embedded options.
- Maturity: The longer the bond’s maturity, the greater the bond’s price sensitivity to interest rate fluctuations.
- Coupon rate: The lower the coupon rate, the greater the bond’s price sensitivity to changes in interest rates. Note that with zero-coupon bonds, their price sensitivity is the greatest when compared to coupon-bearing bonds of the same maturity and trading at the same yield.
- Embedded options: Let us first explain what embedded options in a bond are. If a bond is callable prior to its maturity date at the discretion of an issuer, this bond has an embedded option. But this particular option is not favorable to an investor.Why? Simply, if interest rates decline, the issuer may find it beneficial to call the bond prior to its maturity date in order to refinance the debt issue at lower interest rates, even if it means paying a higher price. Unfortunately, the investor has no say in this, and therein lies the interest rate risk associated with a bond with embedded options.
Note that this article is a part of the series on risks associated with investing in bonds.
