What Is Interest Rate Risk?

A former resident of Belvedere, California, Michael T. Jackson is the founder of SFG Asset Advisors. Although he retired from the financial industry more than 15 years ago, Michael T. Jackson still feels responsible for helping to guide the firm’s investments strategies. The former Belvedere, California resident, Michael T. Jackson advises the younger generation of investors on portfolio risks, such as interest rate risk. 

Interest rate risk is the possibility that the value of an investment will be impacted by fluctuations in interest rates. The rise and fall of interest rates affect the values of investments such as bonds and stocks, although the impact is stronger with bonds than stocks. In fact, all factors held constant, a rise in interest rates will lower the value of bonds, while a drop in interest rates will increase their value. The two are inversely related. Here’s why:

Fixed-income securities such as bonds are traded in the open market. Suppose the government issues a long-term bond with a 3 percent coupon and then, later on, it issues another bond with a 4 percent coupon. Investors in the market will be more attracted to the new bond that offers a higher interest rate, lowering the demand and value of the older bond. Similarly, if new bonds have lower interest rates, then older bonds are more valuable. However, interest rate risk can be managed by diversifying and hedging.