What is interest rate risk and how do you mitigate it?

What is interest rate risk?

Interest rate risk is the chance that your capital (and investments) can lose value due to changing interest rates. Inflation is rising, which means that the cost of living – and the cost of investing – is also getting higher. By February 2022, inflation had reached a 30-year high of 6.2%, and the Bank of England (BoE) has warned that inflation is likely to hit 8% by the end of Q2.

For bond investors, this poses a serious risk. When inflation goes up, fixed-rate investment vehicles such as bonds lose value. A five-year bond purchased with a 5% interest rate in February 2021 would effectively start losing value the moment that inflation rose to anything over 5%.

In fact, interest rates are one of the primary drivers of a bond’s price – when the interest rates rise, bond prices will also have to rise to keep pace with the market.

There are two key risks involved in bond investing: credit risk; which is the risk that the company or government won’t be able to repay the capital by the end of the bond term; and interest rate risk; which will lower the value of any fixed-rate returns.

In the absence of a substantial credit risk, bondholders should always ensure that they are aware of the interest rate risk, and take steps to offset it.

Interest rates and bond prices move in opposite directions

One key principle of bond investing is that market interest rates and bond prices will always move in opposite directions. When market interest rates rise, the price of fixed-rate bonds fall.

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

Long-term bonds carry more risk, as the longer the term time, the higher the risk that interest rate rises could outpace the returns promised.

Bonds offering lower coupon rates tend to carry a higher interest rate risk than bonds offering higher rates, as they are more vulnerable to market price rises. Therefore, a bond targeting a 2% interest rate across ten years will carry more interest rate risk than a bond targeting 4% across three months.

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

Of course, interest rates can fall as well as rise, making bonds more attractive to investors during periods of economic uncertainty. For instance, during the early months of the Covid-19 pandemic, the UK’s inflation rate sank to 0.7%. Against that economic backdrop, a ten-year bond paying 2% would’ve seemed like a great deal. Two years later, UK inflation has soared past the 6% mark, meaning that a 2% return represents poor value. Many of those bondholders may try to exit their investment early, driving down the value of the bond even further and making it harder to sell holdings.

As a result of this relationship, traders and investors should be particularly wary of interest rate risk when they are buying bonds.
Broadly speaking, there are two types of bond holdings – government bonds and corporate bonds.

Government bonds

Sometimes called sovereign bonds, treasury notes, or gilts, these are debt instruments issued by governments that are seeking to raise cash. The more stable the country’s economy is deemed to be, the lower the risk that the government will default on repayments, and the lower the rate on the bond.

Corporate bonds

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

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How to mitigate interest rate risk

You can offset the risk of interest rate rises by ensuring that you have a diversified investment portfolio, which includes both bonds and equities. You can also use hedging tools to offset the risk of rising rates.

Diversification

You can diversify by adding securities that are less vulnerable to interest rate fluctuations.

Equity investments are uncorrelated with interest rate risk as their performance depends on the success of the company and general stock market movements, rather than inflation and market interest rates. A diversified investment portfolio will contain a mix of both bonds and equities.

If you hold a ‘bonds only’ portfolio, you can also diversify by including a balance of both short-term and long-term bonds.

Hedging

You can mitigate interest rate risk by setting up investments that hedge against the possibility that your bonds could lose value. This is a defensive investment strategy that’s designed to minimise losses, rather than maximise profits.

You can hedge against interest rate risk by purchasing different types of derivatives. This way, you won’t be as vulnerable to rising rates devaluing their bond returns.

You can use derivatives such as spread bets and CFDs to speculate on whether a particular investment is likely to rise or fall in value. By pairing this strategy with a bond portfolio, you can effectively minimise the risk of losses no matter how high interest rates rise.

Techniques for trading on interest rates

You can use both interest rate futures and bond futures to trade interest rate movements. There are four main techniques that can be used here:

1. Speculating on rising interest rates by going short on a bond future or long on an interest rate future
2. Speculating on falling interest rates by going long on a bond future or short on an interest rate future
3. Hedging against interest rate risk by creating and maintaining a diversified portfolio made up of bonds and equities
4. Hedging against inflation by using CFDs or spread bets to diversify your bond holdings

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Interest rate risk summed up

• Inflation is rising, causing interest rates to go up and fixed-rate bonds to lose value
• Interest rate risk happens to all fixed-price assets
• You can manage your exposure to interest rate risk by creating diversified portfolios and using hedging tools
• CFDs and spread bets can be used to help hedge against rising interest rates