Interest Rate Risk
As a general rule, bonds tend to rise in value when interest rates fall, and fall in value when interest rates rise. Usually, the longer the maturity, the greater the degree of price volatility. In the case of callable bonds, both the maturity and call date will factor into price movements in the secondary market.
If bonds are held to maturity (or the call date, if called), investors are typically less affected by price fluctuations in the secondary market. The price volatility is known as interest rate risk and generally is reflected on the brokerage firm's statement pricing. This interest rate risk will impact the price an investor would receive if a bond is sold prior to maturity, but not if a bond matures or is called at par value (typically $1,000 per bond).
Many investors have questions about the inverse relationship between bonds and interest rates. Why are previously issued bonds worth less when interest rates rise, and worth more when interest rates fall?
- When interest rates rise, new issues come to market with higher yields than older bonds, typically making those older ones with comparable maturities worth less. Hence, their prices go down.
- When interest rates decline, new bond issues come to market with lower yields than older bonds, typically making these previously-issued, higher-yielding bonds worth more. Hence, their prices go up.
As a result, investors selling bonds prior to maturity or call date may receive more or less than their original investment.
Rising interest rates will typically reduce the near-term market value of bond investments. Generally, the secondary market price of longer maturities will be more sensitive to changes in interest rates.
Various economic factors affect the level and direction of interest rates in the economy. In general, the overall level of interest rates is likely to increase when the economy is growing, and rates often fall during economic downturns. Similarly, rising inflation can lead to rising interest rates—although this is not necessarily the case, and at some point higher rates themselves become contributors to higher inflation. Moderating inflation will likewise tend to result in lower interest rates. Inflation is one of the most influential factors affecting on interest rates.
In general, the longer the maturity of a bond, the more pronounced the bond price will fluctuate with interest rate changes. Maturity, however, is not a true measure of a bond's volatility.
A bond's maturity, its coupon and its yield to maturity all have an impact on the degree of the price will change in reaction to prevailing interest rates. For example, a 10-year bond with a 4% coupon will be more sensitive to interest rate changes than one paying 7% on par.
Each bond offers its own unique risk profile. A longer-term bond's maturity might tend to counterbalance the impact of a high coupon. Bond volatility can be said to represent an average of the bond's opposing risk factors. This calculation is summarized by bond traders in one word: duration. While based on fairly complex mathematical calculations, duration can be used to predict the change in the value of a bond resulting from each 1% change in interest rates.