 Personal finance PowerPoint presentation. Interest rate risk. Prepare to get financially fit by practicing personal finance. We've been thinking about investment goals, investment strategies. As we do so, we of course need to consider risk. We might want to further break down risk into particular components so we can consider how they might impact our investments and in turn, how they might impact our investment strategy. Some risk components could include inflation risk, that being the value of the dollar going down, a dollar being able to purchase, for example, less goods. During periods of high inflation, your investment return may not keep pace with inflation. Interest rate risk, which is what we'll take a look at in more depth here. The value of bonds or preferred stock may increase or decrease with changes in interest rates. Business failure risk affects stocks and corporate bonds and market risk, the risk of being in the market versus in a risk-free asset. So most of this information can be found at Investopedia, interest rate risk, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated December 31st, 2021. What is interest rate risk? Interest rate risk is the potential for investment losses that result from a change in interest rates. If interest rates rise, for instance, the value of a bond or other fixed income investment will decline, the change in a bond's price, given a change in interest rates is known as its duration. So for example, if you're looking at a bond, it usually has a maturity date and end date, and then you have a fixed return on it, a fixed rate of return. That could be good because if market rates decline, then you have locked in your interest rate, that might be a good thing. However, if interest rates go up and you've locked in your rates where they are and now the rates are higher, that would typically be then a bad thing. Interest rate risk can be reduced by holding bonds of different durations and investors may also allow interest rate risk by hedging fixed income investments with interest rate swaps, options, or other interest rate derivatives. We won't get into those right now, but just note, obviously, diversification in various forms could be something that could hedge problems with regards to interest rate risk with having different investments. If you're looking at the bonds in general for example, or specifically in bonds, you might say, hey, I don't really want all my bonds, for example, to have the same time range, the same start and maturity date. Maybe I stagger the bonds so that they mature at different times. And as they mature, then I have the exposure possibly to be picking up the new market rate, for example. So those are some ways that you might mitigate some of the interest rate risk. So understanding interest rate risk, interest rate changes can affect many investment, but it impacts the value of bonds and other fixed income securities most directly. So when you think about something like stocks, for example, that in stocks, you're not really locking in the rate of return, you're basically gonna be based on the market with regards to the return. If you buy bonds, for example, or a bond, you're basically saying I wanna have a fixed rate of return, which can have some pros and cons to it. So bondholders therefore carefully monitor interest rates and make decisions based on how interest rates are perceived to change over time. So, and again, if you're investing in the long-term, then you might be thinking of bonds as kind of a general category, as opposed to doing the day-to-day trading of bonds where you're trying to outguess basically the market. So you've got to be thinking about what is your perspective on your overall investment strategy as we consider these concepts. For fixed income securities as interest rates rise, security prices fall, and vice versa. This is because when interest rates increase, the opportunity costs of holding those bonds increases, that is the cost of missing out on even better investments is greater. So in other words, if you have a locked-in rate and the market rates go up, then you might be able to invest somewhere else if you have the money free to do so and possibly get a greater return. So the rates earned on bonds, therefore, have less appeal as rates rise. So if you're in a period of rising rates, then you're thinking, I don't wanna lock myself into a fixed rate at this point in time because market rates seem to be on the increase. Now, obviously, when you look at these factors and you consider it in the whole market condition, then you gotta think, well, is the market taking into consideration and valuing the fact that the whole market thinks the price is rising? Is that already in the market price? So again, it's difficult to kind of out-guess the market. So in any case, so you wanna think about, am I in a short-term perspective or a long-term perspective? I don't wanna get too in the weeds, possibly, if I'm in a long-term perspective on the day-to-day nuances that will be happening. So in any case, so if a bond paying a fixed rate of 5% is trading at its par value of $1,000 when prevailing interest rates are also at 5%, it becomes far less attractive to earn that same 5% when rates elsewhere start to rise to say 6% or 7%. So if you have an investment that's given you a fixed return of 5%, that might be great if that's what the market rate is, but if other investments are now earning 6% or 7% and you had the money freed up, it might be nicer to be putting it in other investments at that time, that's the point. In order to compensate for this economic disadvantage in the market, the value of these bonds must fall because who will want to own a 5% interest rate when they can get 7% with some different bonds? So then we can talk about basically the value of the price of bonds, which gets a little bit complex to consider, but we might dive into that a little bit later. Obviously, again, is what will happen, the price of the bonds will go down to compensate for the fact that the rate of return that you are receiving is less than the market weight. So therefore, for bonds that have a fixed rate when interest rates rise to a point above that fixed level, investors switch to investments that reflect a higher interest rate. So if interest rates on the market go up, they're not gonna be buying the bonds with the lower rate unless they decrease the price of those bonds. So securities that were issued before the interest rate change can compete with new issues only by dropping their prices. So interest rate risk can be managed through hedging or diversification strategies that reduce the portfolio's effective duration or negate the effect of rate changes. For more on this, you can see managing interest rate risk. So example of interest rate risk, for example, say an investor buys a five-year $500 bond with a 3% coupon. So that's gonna be your earnings on it, right? So it's a 500, we're paying for it, we're getting a return of the 3%. Then interest rates rise to 4%. So the investor will have trouble selling the bond when a newer bond offers with more attractive rates into the market. So 3% was good at that point in time, but now market rates have gone up. If they wanna sell the bond, then they're not gonna be able to sell it. You're gonna have to reduce the price, you would think to sell it because market rates are now higher. So the lower demand also triggers lower prices on the secondary market. The market value of the bond may drop below its original purchase price. So the reverse is also true. A bond yielding 5% return holds more value if interest rates decrease below this level since the bondholder receives a favorable fixed rate of return relative to the market. So having a fixed rate isn't always bad, of course, because if you had the rate at the 3% and then the market rate goes down, well now you have more, your bond is paying out more. So then you might sell it at a premium as opposed to a discount. So bond price sensitivity, the value of existing fixed income securities with different maturity dates declines by varying degrees when market interest rates rise. This phenomenon is referred to as, quote, price sensitivity, end quote, and is measured by the bond's duration. For instance, suppose there were two fixed income securities, one that matures in one year and another that matures in 10 years. When market interest rates rise, the owner of the one year security can reinvest in a higher rate security after hanging onto the bond with a lower return for only one year at most, but the owner of the 10 year security is stuck with a lower rate for nine more years. So obviously if you have a longer term bond and the interest rates go up, then if you wanna hold on, if you're gonna hold on to it for the duration before you get the maturity money, the money at maturity, then you'd have a longer timeframe that you would be holding onto it and possibly getting less of a return than you would otherwise be getting if you had the money that you could invest elsewhere because the interest rates in the market are now higher. So that justifies a lower price value for the longer term security. The longer a security's time to maturity, the more its price declines relative to a given increase in interest rates. Note that this price sensitivity occurs at a decreasing rate. A 10 year bond is significantly more sensitive than a one year bond, but a 20 year bond is only slightly less sensitive than a 30 year one. So the maturity risk premium, a long-term bond generally offers a maturity risk premium in the form of a higher built-in rate of return to compensate for the added risk of interest rate changes over time. The larger duration of long-term securities means higher interest rate risk for those securities. To compensate investors for taking on more risk, the expected rates of return on longer term securities are typically higher than rates on short-term securities. This is known as the maturity risk premium. Other risk premiums such as default risk premiums and liquidity risk premiums may determine rates offered on bonds.