Investment in fixed-income assets ensures returns and provides a safer option for people looking for risk-free investment options. However, the risk factor is always there in one form or another!

People who invest in fixed-income assets or bonds are prone to interest rate risk. The values of these bonds are subjected to changes in the interest values. So, should they not invest? No, anyone can invest in assets, but before that, it is important to understand the interest rate risk as it will ensure safer investments! So, let's understand what interest rate risk is!

What Is Interest Rate Risk?

Interest Rate Risk is the odds of decline or loss in the value of assets or investments due to changes in the internet rates. The risk is usually linked to fixed income assets or investments other than equity investments. The interest rate is directly proportional to the fixed income asset value and the primary driver for their price.

If the interest rate increases, the value of the fixed income asset (bonds) decreases. But, if the interest rate falls, the value of bonds or any fixed income asset increases. This fluctuation or price change as per the change in interest rates is called its duration.

To cater to interest rate risk, investors can diversify their investment portfolio by investing in different duration bonds and hedging fixed-income investments with different interest rate swaps, options, or any other interest rate derivatives.

Interest Rate Risk Assessment:

The interest rates are inversely proportional to your fixed income assets or investment, which compiles that if the interest rates are higher, your fixed income investment or bonds will lower their values; similarly, if interest rates are getting lower, it will make your fixed incomes asset or investment value higher.

While purchasing bonds, every investor assesses the possibility of changes in the interest rate. If the interest rate increases, they will give up the opportunity to buy bonds that make attractive returns because these returns will lose their attraction against higher interest rates.

In the same way, bonds with lower returns will face a decline in their value as a new investment opportunity arises than the bonds with a higher return value. Change in interest rate is an ever-happening phenomenon; however, the rate of fluctuation that matters the most, different bonds, shows the different rate of sensitivity against the interest rate fluctuation.

Generally, bonds with a shorter maturity timeline are less prone to changes in interest rates; in other words, they are more stable than bonds with a longer maturity timeline. Bonds with long maturity timelines are more sensitive to interest changes and risk changing their value over time.

Interest Rate Risk Example:

Let's assume Sally purchased a $1000 five-year bond at an interest rate of 3 percent. After sometimes the interest went high to 4 percent; now, with this new offering, people will tend to buy the bonds with higher interest rates at 4% rather than the old 3% bonds. It will decrease the value of sally's bond as no one is willing to invest at a low-interest rate.

Similarly, in the secondary market, if sally wants to sell her bond, then she will not get the prices at which she purchased her bond due to better options at better interest rates. Therefore she has to compromise on the bond purchased value as well.

Price Sensitivity:

Another notable factor to consider while purchasing bonds is bond price sensitivity. Price sensitivity is the ratio at which the value of the bond varies when the interest rate rises; it is usually linked to the bond's maturity or duration.

For better understanding, let's assume there are two fixed-income securities, one with maturity due in one year and the other taking 10 years to mature. The security with a shorter duration allows the investor to invest in other securities if the interest rate rises. They have to wait for only a year till their security matures.

However, the person whose securities took 10 years to mature has to face more loss in the form of bond value and is stuck for 10 years till they can reinvest that amount. Therefore short-term investment is less prone or less sensitive to interest rates than the long terms one.

Maturity Risk Premium:

To minimize the risk and to encourage investors to invest in long terms bonds, a maturity risk premium is offered to the investor. It's an added value on top of your bond maturity value; due to larger long-term investment risks, these premiums are introduced to compensate investors

Usually, bonds with long-term maturity pay higher returns than those with short-term maturity plans.

Interest Rate Risk Management:

The interest rate risk can be reduced by doing risk management; there are many ways to minimize interest rate risks, and the most common of them are as follow:

Diversify your Investment Portfolio:

Uncertainty in interest rates can significantly affect your investment portfolio, especially if your portfolio mainly focuses on bonds. You can minimize the effects of changes in interest rates by diversifying your portfolio by adding securities less prone to change in interest rates, for example, equity.

Diversify your portfolio by investing in long-term and short-term bonds if your portfolio is all about bonds. Short-term bonds will work as compensation for your long-term bonds if the interest rate fluctuates.

Hedging:

The effects of interest rate risk can also be minimized by adopting and implementing different hedging strategies. These strategies involve purchasing derivatives, including interest rate swaps and future and forward rate agreements. Other options include caps, embedded options, floors, and collars.

All these hedging products are used in different scenarios and have their pros and cons; however, they also have their opportunity cost. It is up to the investor to intelligently decide which product is suitable for their scenario and whether they are ready to give up on one option and opt for the other.

Final Thoughts:

The interest rate risk is the devaluation of a fixed income investment or asset according to the change in interest rates. Usually, bonds are considered the most common fixed income investment; the interest rate is inversely proportional to their value. This asset class is always prone to change in value as interest rates keep changing over time. But one can minimize the interest rate risk by applying different risk management strategies.