The changing interest rate environment has prompted many individuals to examine their borrowing and take advantage of lower rates. The affect of the current lower rates has also been felt as individuals invest in or renew CDs. Lower borrowing rates have been coupled with lower rates being paid on savings accounts and CDs. Borrowers have been happy while savers have been less happy.
What is interest rate risk?
One lesser-understood affect of changing interest rates is how changing rates cause the value of fixed income investments to rise or fall. This is called interest rate risk. When interest rates rise, the values of fixed income investments, like bonds, fall. Conversely, when interest rates fall, the values of bonds rise.
This happens because the values of bonds are determined in the marketplace. There are thousands of traders and investors that are constantly buying and selling bonds. The prices at which they will buy and sell are based on the existing interest rate environment.
The amount by which the values rise or fall is primarily dependent on the maturity of the bond. The longer the maturity a bond has, the greater its value will change when interest rates change. For short-term bonds, like 90 day Treasury Bills, the impact of changing rates is very small.
For a 30 year Treasury Bond, a 1% rise in the interest rate can result in as much as a 12% drop in value. A 2% rise in rates can result in a fall of 22% in value. If interest rates fall, the values of bonds will rise, but not quite by the same percentages (because of the way the present value calculations work).
If you include bonds (or other fixed income investments) in your portfolio, you should understand that their values can fluctuate with changes in interest rates.
How should you consider interest rate risk in your investment strategy?
- Just be aware that long-term bonds can and do rise and fall in value.
- If you expect to need funds that you want to dedicate to fixed income investments, keep the maturities short so unexpected changes in interest rates do not have as much of an affect. For example, for very short-term needs, a 90-day Treasury Bill may be attractive.
- If you buy certificates of deposit, you can avoid the fluctuation, but may be subject to losing some interest if you redeem them before their maturity.
- Finally, be aware that the market forces that cause bond values to rise and fall also affect fixed income mutual funds. The portfolio manager may try to mitigate the risks with different hedging strategies, but the value of these types of mutual funds do rise and fall. When investigating fixed income mutual funds, consider the average maturity of the portfolio and be cautious of claims that hedging strategies can eliminate interest rate risk.
Interest rate risk is just another factor to consider when building your portfolio. Staying with shorter-term bonds can reduce this risk and should be considered just like the quality of the institution issuing the bonds.