The Basics of Interest Rate Risk

Unlike with individual stocks, whose values can soar or plunge depending on the latest headlines, the payoffs from investing in bonds tend to be more predictable. Most bonds offer a set of periodic interest payments, with the initial principal returned when the bond matures. But that doesn’t mean that bonds—even bonds issued by the US government—are risk-free. Since (for typical bonds) the payments are set in stone when the bond is first issued, changes in interest rates can dramatically affect how much these payments are worth.

Because the future payments on a bond aren’t altered when interest rates on other investments change, a rise in interest rates causes the value of these payments (and therefore the price of the bond) to decrease. But by how much will the price fall? Fortunately there’s a number that answers that question. A statistic called “duration” is a rough estimate of how much the price of a bond will change (as a percentage) if interest rates move by one percentage point.

One of the key factors that determines the duration of a bond is the amount of time until the bond matures. Since there’s more time over which a change in interest rates can affect the value of longer-term bonds compared to shorter-term bonds, a rise in interest rates will tend to hit longer-term bonds harder. For example, the duration for the Vanguard Short-Term Bond ETF is 2.7 while the duration for the Vanguard Long-Term Bond ETF is 14.2. In other words, the effect of a change in interest rates will be about 5 times greater for the long-term bond fund.

For investors concerned about rising interest rates hurting their bond holdings, this difference reveals a simple way to reduce interest rate risk. Shifting part of a bond portfolio toward shorter-term bonds can make it much less sensitive to changes in interest rates.

Topics: Blog Risk Bonds Duration Interest Rates