The changing interest rate environment has prompted many individuals to
examine their borrowing and take advantage of lower rates. The affect of the
current lower rates has also been felt as individuals invested in or renewed
CDs. Lower borrowing rates have been coupled with lower rates being paid on
savings accounts and CDs. Borrowers have been happy while savers have been
less happy.
What is interest rate risk?
One lesser-understood affect of changing interest rates is how changing
rates cause the value of fixed income investments to rise or fall. This is
called interest rate risk. When interest rates rise, the values of fixed
income investments, like bonds, fall. Conversely, when interest rates fall,
the values of bonds rise.
This happens because the values of bonds are determined in the
marketplace. There are thousands of traders and investors that are constantly
buying and selling bonds. The prices at which they will buy and sell are
based on the existing interest rate environment.
The amount by which the values rise or fall is primarily dependent on the
maturity of the bond. The longer the maturity a bond has, the greater its
value will change when interest rates change. For short-term bonds, like 90
day Treasury Bills, the impact of changing rates is very small.
For a 30 year Treasury Bond, a 1% rise in rate can result in as much as a
12 % drop in value. A 2% rise in rates can result in a fall of 22% in value.
If interest rates fall, the values of bonds will rise, but not quite by the
same percentages (because of the way the present value calculations work).
If you include bonds (or other fixed income investments) in your
portfolio, you should understand that their values can fluctuate with changes
in interest rates.
How should you consider interest rate risk in your investment
strategy?
1. Just be aware that long-term bonds can and do rise and fall in
value.
2. If you expect to need funds that you want to dedicate to fixed income
investments, keep the maturities short so unexpected changes in interest
rates do not have as much of an affect. For example, for very short-term
needs, a 90-day Treasury Bill may be attractive.
3. If you buy certificates of deposit, you can avoid the fluctuation, but
may be subject to losing some interest if you redeem them before their
maturity.
4. Finally, be aware that the market forces that cause bond values to rise
and fall also affect fixed income mutual funds. The portfolio manager may try
to mitigate the risks with different hedging strategies, but the value of
these types of mutual funds do rise and fall. When investigating fixed income
mutual funds, consider the average maturity of the portfolio and be cautious
of claims that hedging strategies can eliminate interest rate risk.
Summary
Interest rate risk is just another factor to consider when building your
portfolio. Staying with shorter-term bonds can reduce this risk and should be
considered just like the quality of the institution issuing the bonds.
