What is interest rate risk and how to mitigate it

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According to the SEC, interest rate risk is common to all bonds – even government-issued bonds.

Long-term bonds carry more risk because the longer the duration, the greater the risk that interest rate increases will exceed promised returns.

Bonds offering lower coupon rates tend to carry greater interest rate risk than bonds offering higher rates because they are more vulnerable to market price increases. Therefore, a bond with a ten-year interest rate of 2% will carry more interest rate risk than a bond with a three-month interest rate of 4%.

Inflation is calculated on a monthly basis, so the three-month bond paying 4% only has to withstand three potential interest rate hikes, compared to the ten-year bond which will have to support 120.

Of course, interest rates can go down as well as up, making bonds more attractive to investors in times of economic uncertainty. For example, during the first months of the Covid-19 pandemic, the UK inflation rate fell to 0.7%. In this economic context, a ten-year bond paying 2% would have seemed like a bargain. Two years later, inflation in the UK has passed the 6% mark, which means that a return of 2% represents poor value. Many of these bondholders may try to exit their investment early, further lowering the value of the bond and making it more difficult to sell their holdings.

Because of this relationship, traders and investors should be especially wary of interest rate risk when buying bonds.
Broadly speaking, there are two types of bonds: government bonds and corporate bonds.

Government bonds

Sometimes called sovereign bonds, treasury bills or gilts, these are debt securities issued by governments seeking to raise funds. The more stable the country’s economy is considered, the lower the risk of government default and the lower the rate of the bond.

Corporate bonds

Like government bonds, corporate bonds can be issued by any company seeking to raise funds. Companies are assigned a credit rating by rating agencies such as Standard & Poor’s, Moody’s or Fitch Ratings. As with government bonds, the higher the company’s credit rating, the lower the yields, reflecting the lower perceived risk. The higher the rate, the greater the risk that the company could default on its bond repayments.

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