Interest Rate Risk in Fixed Income

Executive Summary

Interest rate risk refers to the possibility that changes in prevailing market interest rates will affect the value of a fixed rate bond, generally causing its price to fall as rates rise and to rise as rates fall. It is arguably the most fundamental risk category in fixed income investing, affecting virtually all fixed rate securities to varying degrees, regardless of issuer credit quality. This article explains, in general terms, how interest rate risk arises, how it is commonly measured, and some general approaches investors may consider when thinking about managing this exposure.

How Interest Rate Risk Arises

Interest rate risk stems directly from the fixed nature of a bond's coupon. Once a bond is issued with a set coupon rate, that rate does not change, even as broader market interest rates move over the life of the bond. When prevailing rates for comparable maturities rise above a bond's fixed coupon, that bond's relative attractiveness declines, and its market price generally needs to fall to bring a new buyer's yield to maturity in line with the higher prevailing rate. This dynamic applies across the credit spectrum — even a bond issued by the highest credit quality government issuer is exposed to interest rate risk, because its fixed coupon does not adjust to reflect subsequent changes in the broader rate environment.

This is an important distinction for investors to internalise: interest rate risk and credit risk are separate risk categories. A bond can experience meaningful price decline purely due to rising rates, even where the issuer's underlying creditworthiness has not deteriorated at all.

Measuring Interest Rate Risk

Duration, discussed in detail in our companion article on bond duration, is the primary tool used to estimate a bond's sensitivity to interest rate changes. In general terms, a bond or portfolio with a higher duration will tend to experience larger price swings for a given change in market yields than one with a lower duration. Beyond duration, investors and analysts may also consider the shape of the yield curve, since interest rate risk can manifest differently depending on whether short-term or long-term rates are moving, and by how much relative to each other.

• Duration provides an estimate of price sensitivity to parallel shifts in interest rates.
• Yield curve risk relates to changes in the relative shape of the curve — for example, short rates rising more than long rates.
• Reinvestment risk is a related concept: falling rates can mean that maturing bonds or coupon income must be reinvested at lower prevailing yields.
• Basis risk can arise where a portfolio's interest rate exposure does not perfectly match the specific benchmark being used to assess it.

Interest rate risk cannot be eliminated from a fixed rate bond portfolio — it can only be measured, understood and, to some extent, managed.

The Relationship Between Interest Rate Risk and the Rate Cycle

The general phase of the interest rate cycle can materially affect how investors approach interest rate risk. During periods when central banks are actively raising rates in response to inflation, longer-duration bonds have generally been more exposed to price declines, while during periods of rate cuts or easing cycles, the same longer-duration exposure has generally tended to benefit from rising bond prices, all else equal. This cyclicality is one reason many investors and fund managers actively adjust duration positioning over time, rather than maintaining a static allocation regardless of the broader rate environment — though such active adjustments carry their own risks and are not guaranteed to improve outcomes.

Key Considerations for Investors

• Recognise that interest rate risk applies across the credit spectrum, including high quality government bonds.
• Use duration as a general guide to relative rate sensitivity when comparing bonds or portfolios.
• Consider laddering or diversifying maturities as a general approach to managing concentrated interest rate exposure.
• Distinguish clearly between interest rate risk and credit risk when assessing the cause of any bond price movement.
• Review the general policy stance of relevant central banks as part of ongoing fixed income portfolio monitoring.

Conclusion

Interest rate risk is an unavoidable feature of fixed rate bond investing, affecting bonds of every credit quality to varying degrees depending largely on duration. A clear understanding of how this risk arises, how it can be measured, and general approaches to managing it can support more informed fixed income decision-making. This article is general information only and does not constitute personal financial advice.

Related topics

Information contained within these insights is provided for general information purposes only and does not constitute personal financial advice, an offer or recommendation to acquire or dispose of any financial product. Investors should consider their individual circumstances and obtain appropriate professional advice before making investment decisions.