Interest-rate risk

The risk that prevailing yields move and reprice a bond you already hold, because its fixed coupon must now compete with newly issued bonds paying a different rate.

Example

A 30-year bond with a 4% coupon trading at par falls 27.53% when yields move to 6%; a 2-year bond with the same coupon and issuer falls 3.6668%.

Important

It has nothing to do with the borrower. A government bond of impeccable standing can lose a quarter of its market value with the issuer in perfect health, which is why credit quality alone never describes a bond's risk.

Related terms

  • Duration — The present-value-weighted average time until a bond's cash flows are received (Macaulay duration), and by extension the measure of how much its price moves when yields change. Modified duration is Macaulay duration divided by one plus the yield.
  • Maturity — The date on which a bond repays its par value and the contract ends. Bonds are commonly grouped as short, intermediate or long by how far away that date is.
  • Convexity — The curvature of the relationship between a bond's price and its yield. Because the relationship is a curve and modified duration is a straight line tangent to it, the duration estimate is imprecise, and increasingly so as the move grows.
  • Credit risk — The risk that an issuer fails to make a contracted payment. It is the risk most associated with bonds and, for high-quality issuers, rarely the one that moves the price.

Lessons that explain it

  • Rates up, price down: the mechanism, and exactly how far — A bond's price is not an opinion. Given a yield, it is the present value of a schedule - and the size of the move when yields shift is a number you can compute in advance. (14 min)
  • Four risks, an invisible dealing cost, and why interest is often the worst-taxed return — Credit, rates, inflation and liquidity are four separate risks that a single word - safe - is routinely used to dismiss. The tax treatment of interest is the one most holders never price at all. (12 min)

All 578 terms in the Investing glossary