New investors quickly learn that investing in bonds can help diversify portfolios because bonds are typically less volatile than stocks. And bonds can offer regular income no matter the interest rate environment.
But investing in bonds involves risks, including interest rate and reinvestment risks. These risks can affect individual and professional investors.
Let’s review interest rate risk: how it affects bonds, how it can impact individual and professional investors, how it relates to reinvestment risk and how you can strive to manage bond risks in your portfolio.
What Is Interest Rate Risk?
Current interest rates help determine a new bond’s coupon—that is, how much income you’ll receive from the bond’s regular interest payments. A bond’s coupon is the rate of interest a bond pays annually. So a $1,000 bond with a 3% fixed coupon would pay $30 in interest annually.
While bond issuers set the coupon when they launch the bond, its current yield—the bond’s coupon divided by the current market price—will change as market prices change.
Interest rates and bond prices move in opposite directions. When market interest rates rise, newly issued bonds will offer coupons and yields that align with prevailing interest rates. However, prices on existing bonds generally decline because their yields don’t reflect the higher level of interest rates now available in the market.
Conversely, as interest rates fall, prices of older bonds with higher coupons increase amid rising investor demand for the higher-yielding securities.
Interest rate risk refers to the possibility of a bond losing value due to rising interest rates.
How Changing Interest Rates Impact Bond Investments
If interest rates rise, prices on existing bonds typically fall. Bonds continue to pay interest even as their prices fluctuate, but the near-term total return (price change and yield) may decline.
Examples of Interest Rate Risk Impacting Investors
Individual Investors
Consider a scenario where you buy a bond at a par value of $1,000 with a fixed coupon of 3%.
If market interest rates rise to 4%, newly issued fixed-rate bonds may feature a 4% coupon.
You will have trouble selling your existing bond in the secondary market because newer bonds can provide more attractive yields.
The lower demand will trigger lower prices, and the market value of your 3% coupon bond likely will drop below your $1,000 purchase price. If you sell the bond before it matures, you may incur a loss of principal.
Institutional Investors - Banks
Banks and similar financial institutions must carefully manage bond risks. In addition to making loans, banks may also invest money in bonds and other debt securities for current income to fund customer withdrawals and other business needs.
But even professionals in the banking sector can mismanage interest rate risk. Consider Silicon Valley Bank (SVB).
SVB experienced rapid deposit growth between 2019 and 2022. The bank parked its deposits primarily in longer-maturity, fixed-rate bonds at prevailing interest rates, which were lower in those years. Then the Federal Reserve (Fed) began raising interest rates in early 2022.
As interest rates rapidly rose, the value of the bank’s bond holdings—particularly its longer-duration securities—declined.
The bank needed to pay higher interest rates on its deposits to keep existing account holders and attract new business.
However, SVB’s large venture capital client base wasn’t attracting enough new deposits to offset bank withdrawals.
With withdrawals growing, management had to sell securities to raise cash. But those securities had declined in value, given the rising-rate environment.
Some banks are better than others at managing these risks, and our investment professionals found SVB's downfall to be company-specific. However, the revelation of SVB’s risky business practices led to renewed investor scrutiny of the entire banking sector and the combination of federal, state and regulatory agency oversight.
Measuring Bonds’ Interest Rate Sensitivity With Duration
Although the prices of all bonds are affected by interest rate fluctuations, the magnitude of the change varies. Duration, expressed in years (but is not the same as a bond’s maturity), is a key measure of a bond fund’s sensitivity to interest rate changes.
The longer the duration, the more a bond’s value will rise or fall with changes in market interest rates.
How Duration Can Help You Manage Interest Rate Risk
Investors can’t eliminate interest rate risk, but they can seek to mitigate it by looking at their mix of longer- and shorter-duration bonds.
If investors think interest rates have peaked and will likely move lower:
Focus on Longer-Duration Bonds
Investing in longer-duration, higher yielding bonds or funds when interest rates are high offers price appreciation potential if interest rates fall.
If investors think interest rates have not peaked and will continue to rise:
Focus on Shorter-Duration Bonds
Investing in shorter-duration bonds or funds when interest rates rise may help limit price declines because their prices are less sensitive to changes in interest rates.
Keeping an Eye on Reinvestment Risk
Reinvestment risk is another element to consider. This risk is the inability to reinvest money into securities that will earn the same or higher rates as your original investment.
Going back to our bond example with the 3% fixed coupon, what if interest rates fell to 2%? You would first be a happy investor because your bond’s price likely would rise above your $1,000 purchase price—as interest rates fall, bond prices generally rise. The 3% bond pays more than newly issued bonds at 2%.
However, suppose your bond matures in a year, and you want to purchase another bond. You would reinvest your principal in a lower interest rate environment, and your new bond investments will not earn as much as before.
When it seems that the Fed might cut interest rates, investors may face growing reinvestment risk. Yields on short-maturity bonds and cash equivalents tend to move in sync with the federal funds target rate. So, if the Fed cuts rates, yields on savings accounts, Treasury bills, certificates of deposit and other similar investments likely will fall too.
Reinvestment risk is heightened when the yield curve is inverted; that is, when shorter-maturity yields are higher than longer-maturity yields. As the yield curve shifts to its normal upward slope—typically when the Fed starts cutting rates—shorter-maturity yields will lose their relative attractiveness. (Learn more about what the shape of the yield curve can tell investors.)
Having some longer-maturity bonds or bond funds may help mitigate reinvestment risk in this situation. Adding duration with longer maturity holdings may help generate capital appreciation when rates fall. However, if rates have not yet peaked, this move would increase your interest rate risk.
As Rates Move, Risk Exposures Change
Interest Rate Risk | Reinvestment Risk | |
If Interest Rates Rise... | ⇧ | ⇩ |
If Interest Rates Fall... | ⇩ | ⇧ |
Some Ways to Help Manage Bond Risks
Diversify Holdings With Higher-Yielding Bonds
Corporate bonds or mortgage-backed bonds are typically less sensitive to interest rate changes than Treasuries and thus can diversify high-quality bond portfolios. But keep in mind that these bonds are typically riskier than Treasuries and add exposure to another risk—credit risk.
Spread Out Bond Maturities With Bond Laddering
Bond laddering is a strategic approach that many active managers of diversified fixed-income portfolios use to manage interest rate risk. It involves having bonds with different maturities so you have smaller amounts to reinvest over time.
For instance, if investors have $50,000 to invest, they might divide that into equal parts and put $10,000 each in bonds that mature in one, two, three, four and five years. When the one-year bond matures, investors use the proceeds to buy a new five-year bond at the prevailing market rate.
If interest rates have risen, investors have the opportunity to buy a bond offering a higher yield.
If interest rates have fallen, the investor may still buy a new five-year bond to keep the bond ladder in place. However, the other bonds in the portfolio may continue to yield returns more elevated than the current market rates for new bonds.
