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Interest rate risk is inherent in assets that are influenced by shifting interest rates. It's an important factor to consider when investing in certain financial securities, such as bonds, and can also give you some insight when applying for a loan.
Here's what you need to know about how interest rate risk works and what you can do to minimize your exposure to it.
Interest Rate Risk Definition
Interest rate risk refers to the threat that an asset's value will fluctuate due to changes in underlying market interest rates.
For example, if you buy a $1,000 bond with a 4% coupon rate, that means you'll earn $40 in annual interest payments. But if a similar bond sells a year later with a 5% coupon rate, you've given up your opportunity for a more attractive return by buying the original bond.
As a result, your bond will lose value because it offers less income than what's currently available.
While you may be able to sell the bond and use the proceeds to buy an asset with a new, higher rate, you'll likely need to accept a lower amount than what you paid because the coupon rate is no longer competitive.
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Interest Rate Risk's Impact on Investors
Fixed-income investments like bonds are particularly susceptible to interest rate risk because their primary value to investors comes in the form of interest payments.
Interest rates for bonds and other fixed-income securities are influenced by a number of economic factors, including inflation, economic growth, government policy, the credit risk of the bond issuer and more.
As a result, the prevailing interest rates on new bonds are fluctuating constantly. And because investors can sell bonds on the secondary market before they reach maturity, that means the value of your investment can change on a daily basis.
That said, there are two sides to interest rate risk. If interest rates drop and a comparable bond to one you own is selling with a lower coupon rate, the market value of your bond will increase because it offers a more attractive income stream than what's currently available.
Interest Rate Risk's Impact on Borrowers
You'll also come across interest rate risk when applying for a loan, particularly when you're choosing a repayment term and interest rate type. That's because loans function as assets to the financial institutions that originate them.
Repayment Term
When a lender originates a loan with a fixed interest rate, they're giving up the opportunity to use those funds for other loans. If market interest rates for new loans increase, the lender can't simply recall the loan and originate a new one at a higher rate.
To compensate for that risk, lenders typically charge higher interest rates on loans with longer repayment terms, partly because there's a greater likelihood that interest rates will increase drastically over a longer term than a shorter one.
Variable vs. Fixed Interest Rate
If lenders anticipate that interest rates will increase, they may offer a lower upfront rate if you choose a variable rate over a fixed rate. That's because the lender can adjust your loan's rate along with market rates, effectively offloading some of the interest rate risk onto you.
If rates are likely to go down, however, variable-rate loans may cost more than fixed-rate loans upfront.
How to Minimize Your Interest Rate Risk
Whether you're planning to invest in fixed-income securities or take out a loan, here are some steps you can take to minimize your exposure to interest rate risk:
- Diversify your portfolio. If you plan to invest in bonds, you can diversify your portfolio by investing in different types of bonds with varying degrees of risk. Additionally, spreading your investments across different asset classes, such as stocks, funds and real estate, can ensure that you're not overexposed to risks associated with any individual asset.
- Invest in varying durations. Fixed-income securities with shorter durations don't create as much interest rate risk because there's less time for market rates to change drastically. At the same time, bonds with longer durations may offer higher yields, so having a good balance of the two can help you minimize your risks without sacrificing your return potential too much.
- Choose shorter loan terms. When borrowing money, opt for a shorter repayment term if you can afford it. While the lower monthly payment of a longer repayment term is tempting, you may end up with a higher interest rate and more total interest charges.
- Opt for a fixed interest rate. In most cases, it's best to choose a fixed-rate loan over a variable-rate alternative because it prevents you from taking on the risk of fluctuating market rates. However, it can make sense to opt for a variable-rate loan if you have good reason to believe that interest rates will decrease over time. What's more, an adjustable-rate mortgage loan can offer a lower fixed rate for a handful of years, giving you some time before you need to worry about changing market rates.
The Bottom Line
Whether you're an investor or a borrower, it's not possible to completely eliminate the risk that interest rates can have on your investment portfolio or loan. However, understanding how interest rate risk works and the steps you can take to minimize the impact of that risk can help you make the most of your financial situation and reach your goals.