Investor Corner/The asset classes/Debt Concepts
2.2.5 Interest-Rate Risk
Interest-rate risk is the risk that bond prices fall when interest rates rise, and rise when rates fall. It affects every bond to some degree, though longer-maturity and lower-coupon bonds feel it more.
Why bond prices move opposite to rates
A bond issued with a 6% coupon becomes less attractive the moment new bonds start being issued at 8%, because investors can now get a better fixed return elsewhere. The market corrects for this by pushing the price of the older, lower-coupon bond down until its yield becomes competitive with the newer ones. The reverse happens when rates fall: existing higher-coupon bonds become more attractive, and their prices rise.
Who feels this most
This risk is directly tied to duration. A long-maturity, low-coupon bond fund will feel a rate move far more sharply than an overnight or liquid fund, whose short maturities mean its holdings are constantly rolling over into whatever the current rate happens to be. This is exactly why debt funds are categorised by duration in the first place.
Managing it rather than avoiding it
Interest-rate risk cannot be eliminated from bond investing, but it can be managed by matching a fund's duration to your own time horizon. Money needed soon belongs in short duration or liquid funds, which are far less exposed to rate swings. Money that can stay invested for years can reasonably take on more duration risk in exchange for typically higher long-run yields.
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