What is interest rate risk? - InterestRate.co.uk
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What is interest rate risk?

When reading about interest rates, you often see many terms relating to investors, businesses, and consumers. While all are affected by the interest rate environment, many need help understanding the impact of interest rate movements and fluctuations. These can have a significant effect on market interest rates, which are also known as the effective interest rate. Interest rate risk can affect many groups, from investors and businesses to consumers.

Investor impact

Interest rate risk is the concept of risk relating to changes in interest rates. The risk presented with fluctuations in interest rates is particularly relevant to fixed-income investments such as corporate or government bonds.

There are two broad scenarios; either interest rates rise, resulting in a decline in the value of fixed-income investments, or interest rates fall, increasing a bond’s value. The changes to a fixed-rate investment’s price in the context of interest rates relate to its duration. This is particularly important to those seeking to immunise fixed-income investments to protect from fluctuations in interest rates, especially in the case of long-term investments.

The longer a bond or fixed-rate investment’s duration, the higher the interest rate risk. This is because the longer investment window is open to additional volatility and impact from interest rate changes throughout time.

You can mitigate interest rate risk by holding fixed-rate assets for different durations.

You can hedge investments with interest rate swaps or other investment options. 


Interest rate risk explained

Interest rate fluctuations can present a risk to a multitude of investments. However, the value of fixed-rate investments such as bonds are more directly related, making quantifying interest rate risk vital to monitor changes in value and yield curve risk over time.

Bond investors monitor interest rate movement and modify their portfolios to account for fluctuating risk, implementing an interest rate risk management strategy. Investors often use sensitivity analysis to predict the impact of interest rate movement on their investments. Some also use embedded options for added protection in the future.

When interest rates increase, the cost of holding a bond also rises. For example, consider a bond valued at £10,000 paying a fixed 5% rate; if interest rates rise to 7%, the opportunity cost of the bond also increases.

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Earning 5% on the bond becomes less attractive when rates rise beyond 5% to 6%, 7%, or higher. This means the investor is likely missing out on a better investment opportunity. Thus, higher interest rates confer an economic disadvantage to those holding bonds at lower interest rates.

When interest rates rise, an astute investor will switch investments or hedge to take advantage of those higher interest rates rather than be left with low interest rates on their investments. When switching investments, investors may choose to reduce the bond portfolio’s duration. Diversification is an integral part of tackling interest rate risk. Some will turn to interest rate derivatives based on a benchmark interest rate to tackle market risk.

Interest rate risk example

Here is a breakdown of a scenario where a fixed-income investment is affected by interest rate risk:

  • An investor purchases a 5-year £1,000 bond with a 5% coupon rate.
  • The interest rates then rise to 6%
  • When newer bonds reflecting the increased interest rate reach the market, the bond declines in value
  • Lower demand also results in falling prices across secondary markets
  • In some situations, the value of the bond can drop below its original price

The inverse is also true. The same 5-year £1,000 bond will become more valuable if interest rates fall below 5%. This is simply because the 5% bond pays better than other products.

Bond price sensitivity

The fluctuations in the value of fixed-rate investments also vary with their maturity date and duration.

Duration is a calculation of all the known factors that affect a bond’s price, and there are different approaches to calculating it. Bond prices and price sensitivity are related to their duration.

For example, imagine there are two fixed-rate bonds with different maturities. One short-term bond matures in one year, another in five years. If the interest rates rise, you can reinvest the 1-year bond after the 1-year period is up, thus lowering your exposure to interest rate risk. But conversely, the bondholder of the 5-year security has to hold onto their lower rate bond for another four years.

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The longer the holding period before maturity, the more its value can decline due to interest rate rises. The inverse is also true. A bond with longer maturity and duration will be more valuable than a shorter one if the interest rates fall.

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Understanding maturity risk premiums

Another comparative factor that differentiates bonds offered with a longer maturity is the maturity risk premium. Long-term bonds usually have higher rates designed to compensate for the added interest rate risk exposure. So, although you will have to cope with the interest rate risk for a more extended period, you can benefit from this financially due to the higher interest payments.

This higher interest rate is designed to compensate investors who take on bonds with a more extended maturity period and higher interest rate risk. Some investors are happy to do this, as the higher return makes up for the increased risk.

Impact on businesses

Above, we have discussed how interest rate risk affects investors. However, interest rate fluctuations can also impact businesses, affecting everything from liquidity risk to market value. There is interest rate risk for companies. Small businesses can often be the most affected because of their financial instability.

One of the critical risks relates to the length and terms of loans for both lending and borrowing. For instance, many small businesses take out loans at a variable rate. So, although they benefit when interest rates fall, they have to pay more when they rise. This can lead to many issues, including an impact on cash flow due to higher repayments.

Rising interest rates can also increase your business’s credit risk, as you will be paying more interest and have less slack in your finances. As a result, getting business loans and credit moving forward can become more complex and expensive.

You also have to consider foreign exchange rates, as this will be a factor if the business has any foreign debt on the balance sheet. For example, if the pound weakens, you will pay more interest on foreign loans and debts because the pound is worth less.

One of the other things to keep in mind is that consumers are also affected by interest rate fluctuations. This means they could end up in a situation where they can only afford necessities. As a result, sales could slow for your business and impact your bottom line. Therefore, as a small business, you must ensure you have an interest rate risk management strategy.

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The impact on consumers

Fluctuations in interest rates and the interest rate environment can also significantly impact consumers with financial liabilities such as variable-rate mortgages and loans. When banks announce interest rate hikes, financial institutions quickly apply the increased interest rate to borrowers but are often slow to do the same for savers.

In cases where interest rates have increased significantly, such as across 2022 and into 2023, many financial institutions put stress testing into action to determine affordability for their customers and put support into place. However, even with support from lenders, many borrowers are hit hard by interest rate hikes.

When the Bank of England puts up interest rates by, say, 50 basis points, it can make a massive difference to the loan and mortgage repayments for those on variable or floating rates. Those with fixed-rate loans do not feel the impact – at least, not immediately. However, interest rates will impact them once their fixed period ends should they need to refinance or find a new deal.

On the flip side, those with fixed-rate loans face the risk that interest rates fall. If the rate of interest falls after they have taken out their loan at a specific rate of interest over a specified period, they will continue paying the higher rate of interest. This is a risk that they take when signing up for the fixed-rate deal. However, when it comes to bigger loans such as mortgages, many prefer to face that risk than the risk of soaring interest rates on a variable-rate mortgage.

Another thing to consider is the impact on house prices and valuations. The present value of a property could fall if interest rates rise. Increased interest rates mean lower affordability and less demand for properties, affecting the market price.