Interest Rate Risk - Definition and Meaning

What You Need To Know About The Interest Rate Risk

When interest rates rise, the value of investments with fixed interest payments, such as bonds, decreases. The reason behind it is that new bonds will be issued with higher interest rates, which makes existing bonds with lower interest less attractive to investors. Let’s take a look at an example illustrating the interest rate risk definition.

Suppose you purchase a bond with a fixed interest rate of 3% when interest rates are low. If interest rates rise to 5%, new bonds will be issued accordingly, which means that your bond will inevitably become less attractive to investors. As a result, the value of your bond will decline, and you may not be able to sell it for as much as you paid for it.

While interest rate risk is particularly relevant for fixed-income investments such as bonds, it is applicable in other situations as well. For example, rising interest rates can also decrease the value of dividend-paying stocks.

To manage interest rate risk, investors should remember about the importance of diversification. Imagine that an investor holds only bonds with long-term maturities and fixed interest rates. In this case, their investments may be vulnerable to interest rate spikes, which would decrease the value of their bonds.

However, by diversifying their portfolio to include stocks, commodities, or alternative investments, the investor can reduce their overall exposure to interest rate risk. Note that one must also consider investments with different durations and interest rate sensitivities in the context of diversification.

For instance, shorter-term bonds are not as sensitive to interest rate changes as their longer-term counterparts, which means they are less risky. Moreover, floating-rate bonds, whose interest payments adjust alongside interest rate changes, can be an effective hedge against interest rate risk.