What Is Interest Rate Risk? How It Affects Bonds

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Interest rate risk is the risk that a change in market interest rates reduces the value of an investment, most directly the market price of a bond or other fixed-income security. When prevailing rates rise, existing bonds that pay a fixed coupon lose value. When rates fall, they gain value. The size of the move depends mainly on the bond’s duration, which grows with time to maturity.

How Interest Rate Risk Works

A fixed-rate bond locks in its coupon at issue. Suppose a bond pays 5% and trades at its $1,000 par value while new bonds also yield 5%. If new issues start paying 6% or 7%, no buyer will pay $1,000 for a 5% stream of income, so the older bond’s price drops until its yield matches the market.

If market rates fall to 4%, the 5% bond becomes more attractive and its price rises above par.

What affects a bond’s interest rate exposure

• Time to maturity. A one-year bondholder stuck with a below-market rate can reinvest within a year. A 10-year holder is stuck for nine or ten years, so the price falls further.
• Coupon size. Bonds with higher coupons return more cash earlier, which lowers sensitivity. A zero-coupon bond pays everything at maturity, so its duration equals its maturity.
• Starting yield level. At lower yields, a given change in rates moves prices more.

Sensitivity increases with maturity but at a decreasing rate. A 10-year bond is far more sensitive than a one-year bond, while a 30-year bond is only somewhat more sensitive than a 20-year bond.

Calculating interest rate risk

The standard first estimate uses modified duration:

% change in price ≈ −Modified duration × change in yield (in decimal)

A modified duration of 7 means the price drops about 7% for a one-percentage-point rise in yield, and gains about 7% for a one-point fall. For an exact figure, reprice the bond by discounting its cash flows at the new yield, as with yield to maturity.

Example of Interest Rate Risk

Hypothetical example; assumes annual coupons, $1,000 par, and that both bonds start at par with market yields at 5%.

Two bonds each pay a 5% coupon. One matures in one year, the other in 10 years. Market yields then rise to 6%.

• One-year bond: the single $1,050 payment discounted at 6% is worth about $990.57, a loss of roughly 0.9%.
• 10-year bond: ten $50 coupons plus $1,000 at maturity, discounted at 6%, are worth about $926.40, a loss of roughly 7.4%.

The same one-point rate rise costs the 10-year holder about eight times as much in market value. Its modified duration before the move is about 7.7, so the duration formula predicts a drop of about 7.7%. The actual drop is smaller because of convexity, covered below.

Why Interest Rate Risk Matters

Interest rate risk affects anyone who may need to sell a bond before maturity, and anyone who holds bonds through a fund. Bond funds and ETFs hold a rolling portfolio with no single maturity date, so rising rates show up as a lower net asset value rather than a temporary dip.

Banks face the same risk when short-term deposits fund long-term loans and securities. Rising rates cut the value of long-dated assets while deposit costs climb, squeezing net interest income and capital. Silicon Valley Bank failed in 2023 after a rapid rate rise caused large losses on its long-term securities, combined with deposit withdrawals.

Managing the exposure

• Laddering: spreading holdings across maturities so some bonds come due regularly and can be reinvested at current rates.
• Shortening duration: favoring shorter maturities or floating-rate notes, whose coupons reset with market rates, though their income falls when rates decline.
• Hedging: using interest rate futures, swaps or options to offset price changes in a portfolio.

The Maturity Risk Premium

Because longer-term bonds carry more interest rate risk, investors usually require a higher expected return to hold them. That extra yield is the maturity risk premium, and it is one reason yield curves typically slope upward. A higher yield is not a guarantee of higher realized return.

Limitations of Duration and Related Measures

• Convexity: the price-yield relationship is curved, not straight. Duration overstates losses when rates rise and understates gains when they fall, and the error grows with larger rate moves.
• Parallel shift assumption: a single duration figure assumes all yields move by the same amount. In practice, short and long rates often move differently, so a portfolio can lose value even when its overall duration looks modest.
• Embedded options: a callable bond’s upside is capped when rates fall, because the issuer can redeem it early. For callable bonds and mortgage-backed securities, cash flows change with rates, so effective duration is needed in place of modified duration.

Distinctions Readers Confuse

• Interest rate risk vs. credit risk: interest rate risk comes from market rates changing; credit risk comes from the issuer possibly not paying. A U.S. Treasury bond has very little credit risk but can carry substantial interest rate risk.
• Interest rate risk vs. reinvestment risk: these work in opposite directions. Falling rates raise bond prices but force coupons and maturing principal to be reinvested at lower yields.
• Interest rate risk vs. inflation risk: higher inflation erodes the purchasing power of fixed payments and often pushes nominal rates up, linking the two without making them the same risk.
• Interest rate risk vs. liquidity risk: liquidity risk concerns how easily a bond can be sold, not how its fair value responds to rates.

FAQs

The Bottom Line

Interest rate risk matters most to anyone who may sell bonds before maturity, holds bond funds or ETFs, or runs a bank funding long assets with short deposits. Checking duration gives a quick sense of exposure, though convexity and uneven yield moves limit its accuracy. Laddering, shorter maturities, floating-rate notes and hedging can reduce the risk, and a higher yield on long bonds does not guarantee a higher realized return.