Markets Explained

Understanding Interest-Rate Risk

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Understanding Interest-Rate Risk

Like all bonds, corporates tend to rise in value when interest rates fall, and they fall in value when interest rates rise. Usually, the longer the maturity, the greater the degree of price volatility. If you hold a bond until maturity, you may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because you will receive the par, or face, value of your bond at maturity.

Some investors are confused by the inverse relationship between bonds and interest rates—that is, the fact that bonds are worth less when interest rates rise. But the explanation is essentially straightforward:

  • When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down.
  • When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up.

As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.

Various economic forces affect the level and direction of interest rates in the economy. Interest rates typically climb when the economy is growing, and fall during economic downturns. Similarly, rising inflation leads to rising interest rates (although at some point, higher rates themselves become contributors to higher inflation), and moderating inflation leads to lower interest rates. Inflation is one of the most influential forces on interest rates.

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