Interest rate risk: What is it and how do you manage it?
Interest rate risk: What is it and how do you manage it?
Bonds and other fixed-income products play a large role in the portfolios of most savvy investors.
With guaranteed returns and lower exposure to market volatility, bonds typically don't offer the large potential sums that excite some investors. But increased confidence and opportunity to plan offer great benefits to long-term strategies.
One factor that majorly influences the value of bonds is changes in interest rates. Amid long-standing global financial uncertainty, many central banks across the world steadily increased interest rates throughout 2022. This has had an immediate impact on the value of bonds held the world over.
It's not necessarily true that a bond portfolio's success is entirely dependent on interest rates falling, however. In this article, we will go into more detail on ways that you can work around decisions made by central banks – and manage your interest rate risk (IRR).
What is interest rate risk?
Issuing bonds is a way for organisations such as national and local governments or large corporations to raise funds in a way that is often more cost-effective than taking out a bank loan.
Bondholders will hand over cash, in turn receiving a promise that the sum will be repaid after a defined period (known as maturity) in addition to interest payments (known as a coupon) set at a percentage of the initial investment.
If central banks start to lift their interest rates, it makes the bonds' value fall as the same returns may be available in a fraction of the time elsewhere on the market – this is the inherent interest rate risk of bonds and similar investments.
Of course, interest rate risk is not the only potential pitfall when investing in bonds and other fixed-income products.
Default risk is also at play if you invest in corporate bonds and the company goes out of business. With larger sums typically tied into longer-term investments, it may also be hard for you to quickly pivot to a better opportunity – especially if fluctuations in interest rates have made your bonds less valuable.
While we have so far focused on how interest rate risk affects investors, it is also a factor for banks and other issuers of bonds. The Bank for International Settlements characterises four types of interest rate risk for firms:
- Repricing: As interest rates rise, variable outgoings can hit the coffers of banks and institutions as they pay out more in coupons.
- Yield curve: As is the case with investors, longer-term bonds expose banks to more risk, and their overall financial health – often measured by future yields – can soon worsen.
- Basis: If interest rates switch suddenly, institutions may be caught out with products and rates that are no longer attractive, hitting cash flow hard.
- Optionality: An increased number of options for investors means increased risk for financial centres. For example, the flexibility for investors to withdraw funds when they choose can lead to imbalanced reserves.
Interest rate risk example
If you were to invest in a bond at $1,000 over five years with a 5% coupon, you would stand to gain $50 in interest each year, totalling $250 on top of the $1,000 returned when the bond matures.
You may be able to sell this bond in the intervening period. But if interest rates rise and match the 5% of your bond, it is now worth less, as the wider market is likely to offer better returns. To sell this bond, you would likely have to do so for less than you originally invested.
Of course, the opposite scenario also applies. If you invested in the same bond and interest rates started to fall, it would now be a much more attractive proposition, potentially enabling you to sell it and make a profit quicker than if you had held the bond to maturity.
Bonds and interest rate risk: How are they linked?
Interest rate risk is arguably the biggest risk at play when investing in bonds because the profit you make from the investment comes from the interest payments you receive.
If you're investing in government bonds, IRR may indeed be, in effect, the only risk that you are exposed to as the issuer is not likely to go out of business and your bond will pay out once it reaches maturity. The interest the bond pays out, however, could become less favourable if market forces push interest rates up.
Selling bonds is another common way to profit from them, but this becomes much harder – and much less profitable – when interest rates are just as high elsewhere, if not higher.
What causes interest rate risk?
How much interest rate risk you are exposed to can depend on several factors.
- The longer the term of your bond, the more risk you face as a greater timespan offers more chances for market conditions to change. Just imagine how much IRR models will have fluctuated since the start of 2020 alone…
- Different types of bonds are attached to different interest rates. For example, corporate bonds from riskier organisations – aka junk bonds – come with higher interest rates, leaving you less open to IRR. However, this is generally offset by a much higher default risk, which would see you lose your entire investment if the issuer went bust.
How to manage interest rate risk
Like any other kind of investment risk, your interest rate risk exposure can be mitigated against when you consider your portfolio as a whole. While you can't necessarily stop rising interest rates from affecting the value of your bond investments, you can make sure that you retain value in other areas.
Measuring interest rate risk
Charting previous rises in interest rates can help you attempt to predict the impact of future movements and calculate your interest rate risk. For example, the biggest change in the Bank of England's rate in a decade came in November 2022 when it rose 0.75 percentage points to 3%.
Rising rates will decrease the value of your bonds, so timing a sale right is key to minimising losses. Mapping out what future changes – good and bad – mean to the overall value of your bonds can help you create an optimal sell point.
Hedging interest rate risk
Hedging can help to minimise your risk, especially when investing in corporate bonds, although note this is not a strategy that maximises returns.
Derivatives such as CFDs may enable you to take a short position on the organisation you are a bondholder with. As such, if rates change and your bonds lose value, any drop in the company's price will offer you a return and limit the damage.
Another interest rate risk hedging strategy is to do so with futures. These contracts can often be written to sell assets in the event of interest rates changing, protecting your liquidity.
Diversifying to reduce your interest rate risk exposure
Many alternative investments to bonds are far less likely to be impacted by interest rate risk. For example, the value of equities relies much more on the performance of the relevant company and more obscure assets such as artwork also have their value defined by other factors.
Diversification is also possible in bond-only portfolios. By combining lower-risk government bonds and higher-yield corporate bonds, as well as taking bonds with short, medium and long-term maturities, you offer yourself manoeuvrability in the event of changing market forces altering the value of your holdings.
How to manage interest rate risk with FXCM
Diversification is key if you want to avoid the pitfalls of interest rate risk. The great news is that FXCM offers you the chance to run a varied portfolio all from one place with the Trading Station platform.
Sign up for a free demo today and see how options such as CFD trading can augment the slow-burn success that bonds offer and help you manage interest rate risk more effectively.
Once you're confident in your strategies, open an account with FXCM to put them into practice.
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