Interest rate risk: what is it and how can you mitigate its impact?

Federal reserve building
Rebecca Cattlin
By :  ,  Senior Financial Writer

Interest rate risk tells bond traders how much their portfolio will diminish when a central bank hikes its rates. Learn how to manage interest rate risk with diversification and hedging strategies.

What is interest rate risk?

Interest rate risk is the probability that an asset will decline in value because of unexpected interest rate changes. This risk is most associated with fixed-income assets – such as bonds.

There are other types of market risk for traders to be aware of that impact other asset classes – such as volatility risk, currency rate risk, and liquidity risk.

Interest rate risk on bonds

The price of a bond has an inverse relationship to interest rates. So, when interest rates increase, the value of a bond decreases because newer bonds will come with a more attractive return.

For example, let’s say a bond is paying a rate of 5% and its value is $1000 when prevailing interest rates are also at 5%. It becomes less attractive to earn that same 5% when rates elsewhere start to rise to say 6% or 7%.

To compete with the newer issues, the value of the bond will have to fall from $1000.

Without the price drop, the holder would experience a capital loss, which wouldn’t be realised until they sold the bond on the secondary market or the bond reached maturity.

But the reverse is also true when interest rates decrease, bonds with higher rates become more attractive, and therefore worth more. The same bond yielding 5% would be in demand if interest rates were only 3% or 4%.

Learn about treasury yields

Duration and interest rate risk

Different bonds will be impacted by interest rate risk in different ways. Generally, bonds that have a shorter duration will have a smaller interest rate risk, as there is less time for interest rates to change dramatically enough to impact the bond price.

Bonds with a longer duration, however, have a higher probability of rate change, and so a higher interest rate risk. However, longer durations generally have a lower price value and greater rate of return to account for the added risk. This is known as the maturity risk premium.

Interest rate risk management

There are two common ways of managing interest rate risk: diversification and hedging. Let’s take a look at each risk management strategy.

Diversification

Trading or investing in bonds will always carry interest rate risk, so opening positions on other asset classes that are less impacted by rate fluctuations can help to add balance to a portfolio.

For example, bond traders could look at stocks, especially defensive stocks that aren’t as affected by the economic cycle. This way, when interest rate risk impacts bond prices, the securities might balance out the loss.

But if a bond trader doesn’t want to branch out beyond the asset class, they could diversify by using a combination of short-term and long-term maturities, or bonds from different geographies.

You can also consider using bond mutual funds and exchange traded funds that invest in a collection of bonds with different maturities rather than an individual asset.

Hedging interest rate risk

Hedging interest rate risk involves opening new positions that are intended to offset or minimise the potential loss. It usually involves trading with derivatives, such as futures, swaps or CFDs.

Hedging interest rate risk with futures

A futures contract is an agreement between two parties to exchange an underlying asset – in this case, a bond – on a set date for a predetermined price. This would mitigate interest rate risk, as regardless of the value of the bond at the time, the asset has to be exchanged under the terms of the contract.

Let’s say you have a bond that’s current value is $1000, but you thought it was going to decline due to an interest rate hike. To lock in the $1000, you enter a futures contract to sell the bond in a month at the current value.

If interest rates did rise, and your bond fell in value to $900, you’d still be able to sell it and realise your $1000.

However, if rates remained unchanged or fell – increasing your bond’s value – you’d still have to sell it on the agreed date for $1000.

Hedging interest rate risk with swaps

An interest rate swap is an agreement between two parties to exchange interest payments on an asset. The most common arrangement is for party A to make party B payments based on a fixed interest rate, while party B will pay party A based on a floating interest rate.

So, if a party believes an interest rate would increase in the coming months, and they are paying interest on a fixed-income security, such as a bond, they can use a swap to essentially ‘lock in’ a floating rate.

This would mean that you’d always get the better interest rate if there were price increases, but at the risk of losing out should the rate decline.

These agreements are over-the-counter transactions and are largely used by banks and institutions, rather than individual investors. However, they have become more popular as a gauge for sentiment toward interest rate changes.

Hedging interest rate risk with CFDs

You can hedge against the interest rate risk to your portfolio by taking a speculative position on interest rates with CFDs. These are derivatives that track the value of an underlying rate and allow you to try and predict whether the rates will go up or down.

Unlike tactics such as diversification into stocks, there are no other factors that could influence the market price. The only factor to consider is interest rates, so you get 100% exposure to any change made by central banks.

If you thought interest rates would increase – and lower the value of your bond – you could go long on the CFD interest rate market. If rates did increase, the profit on your CFD trade could go some way in offsetting the loss to your bond. However, if you were wrong, you’d have a losing CFD trade minimising the gains to your bond’s increasing value.

Plus, it’s important to note that while hedging interest rate risk, trading on leveraged instruments – such as CFDs – does open you up to other forms of risk. While margin trading enables you to open a position for a small initial deposit, your profit and loss are based on the full market value – magnifying your outcome. This is known as margin risk.

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