The Definition of Interest Rate Risk
Interest rate risk is the risk of financial loss that investors, businesses and borrowers face when interest rates rise. The risk affects borrowers and lenders differently, depending on the debt instrument, whether bonds, preferred stocks, mortgages or loans.
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Fixed Rate Risk
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Most debt instruments are issued with fixed interest, meaning that the interest rate, once declared as a percentage, is fixed in dollars. Rising interest rates make current fixed income investments less attractive because investors can get higher returns elsewhere. The prices of fixed interest investments must therefore be adjusted downward to make them at par with new investments, while new fixed income investments are issued with a higher rate.
Bondholder Example
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An investor buys $1,000 of a 5 percent bond at face value. The bond pays $50 in interest annually. If interest rates rise to, say, 6 percent, the bond price must be adjusted to $833.33, so the bondholder will see a 16.7 percent drop in the value of his bond with a 1 percent rise in interest rates. Bond mutual fund investors will see a similar decline in the value of their shares.
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Business Risk
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Businesses constantly borrow money to finance ongoing operations. When interest rates rise, the cost of borrowing goes up, which may depress profits or make it difficult or even impossible to borrow.
Bank Risk
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Banks make money by borrowing at short-term rates and lending at long-term rates. For example, a bank pays depositors 1 percent interest and lends their money to home buyers through mortgages at 5 percent. The difference of 4 percent is the bank’s profit. Short-term interest rates rise to 6 percent and long-term interest rates rise to 8 percent. The bank is still collecting 5 percent on its loans but now must pay depositors 6 percent, losing money at a rate of 1 percent.
Variable Rate Risk
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Theoretically, variable rate securities should not decline when interest rates rise because their interest payments go up, but in reality they move almost exactly in concert with fixed rate securities, hurting investors all the same. Variable rate loans hurt borrowers because when interest rates rise, so do the amounts borrowers must pay on their loans. The standard rationale that variable rate borrowers use is that they will save money while interest rates are low and refinance to a fixed rate if rates rise, but if, for any reason, they are unable to refinance, higher payments may push them into serious financial difficulty, default or bankruptcy.
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References
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