Interest Rate Risk

For bond investors, the main form of interest rate risk is that bond prices fall when interest rates rise. Existing bonds paying a fixed rate become less attractive compared with new bonds paying higher rates, so their prices drop.

The size of the effect depends mainly on a bond's duration. As a rough guide, a bond with a duration of 7 will fall in price by about 7% if interest rates rise by one percentage point. Longer-term bonds are therefore more exposed to interest rate risk than short-term ones.

For example, an investor holding a ten-year government bond may see its market value fall noticeably if rates rise, even though the government is certain to repay at maturity. If the investor holds the bond until it matures, they will still receive the full face value.

Interest rate risk also affects borrowers. Those with variable-rate loans face higher payments when rates rise. Banks face interest rate risk when the rates on their loans and deposits adjust at different times.

Investors manage this risk by choosing bonds with shorter durations, spreading maturities over time or using financial contracts such as interest rate swaps.