WiseAlpha’s educational series: Teaching you everything you need to know about the bond market and more.
Our previous article “What causes bond prices to move?” outlined the different factors that affect a bonds price. Today we take a deeper look at one such factor – interest rates.
Interest rate risk is among the principal risks of investing in bonds. Still, the drivers of interest rate risk can remain elusive. WiseAlpha believes it is important to have an understanding of interest rate risk when assessing the appropriateness of an investment.
Interest rates and bond prices typically move in the opposite direction; so when one goes up, the other goes down. Interest rate risk is the risk that prevailing market interest rates will rise and the prices of bonds will fall.
The graphic (above) visualises the inverse relationship between interest rates and bond prices.
Bond prices falling when interest rates rise may seem counterintuitive. However, consider an illustrative example:
You invest £100 in an Aston Martin bond paying a fixed coupon and 3 years left to maturity. If interest rates increase by 1%, investors are able to invest their money in similar credit quality assets earning 1% per year over three years. For that reason, if you decide to sell your Aston Martin bond after the interest rate increase, you will realise a lower price – about -3%, to offset it’s lower relative interest rate. If you choose to hold the bond until maturity you are effectively earning 1% less than bonds of similar credit risk available elsewhere on the market.
The effect of a bond’s maturity on interest rate risk
A bond’s maturity is the date by which the bond holder must pay the principal to bondholders.
For bonds the more time remaining to maturity, the greater interest rate risk. Why? Longer-dated bonds have more forward cash flows (coupons), exposed to any interest rate increase.
The longer the time to a bond’s maturity, the greater its exposure to interest rate risk
Virgin Media 2029 has a greater amount of future cash flows (coupons) at risk of being adversely affected by interest rate movements. Hence, interest risk is more significant.
How can I mitigate interest rate risk?
WiseAlphas looking to mitigate their exposure to interest rate risk might consider:
- Reviewing the maturity of your bonds. The above section demonstrates that longer-term bonds are at greater risk of interest rate movements. Those who worry about rising interest rates can opt to select short term bonds on the WiseAlpha market. You can view a bond’s maturity date on WiseAlpha:
- Buying floating rate bonds. Floating rate bonds have a coupon that periodically resets based on the LIBOR rate. LIBOR is the basic rate of interest used in lending between banks on the London interbank market.
If interest rates increase, coupons on floating rate bonds will reset upwards, mitigating interest rate risk for bondholders. For example, Stonegate’s March 2022 pays a coupon of LIBOR + 6.25%.
Interest rate risk is among the key risks of investing in bonds. The institutional bond market and by extension, WiseAlpha offers several ways for those with a view on interest rates to increase or decrease their exposure to interest rate risk. WiseAlpha offers a number of floating rate bonds such as Premier Foods (link), Domestic & General (link) and Stonegate Pubs (link). Even for those without such views, the relationship between interest rates & bond prices still bears relevance as the cost of corporate financing inevitably impacts the ordinary business of life.
Find out more about investing with WiseAlpha. All factual information true at the time of publishing.
As with all investments your capital is at risk. Invest via our Fractional Bonds.