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Wednesday, December 7, 2022

Why You Should Care About Interest Rates, Mitigating Associated Risks

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The value of bonds can fluctuate up and down based on factors such as the movement of interest rates; this is called Interest Rate Risk, and it affects all bonds regardless of their credit quality. It is the risk or volatility related to bonds or long-term debt as a result of changes in market interest rates, coupons, yields to maturity, and maturity dates.

Strong retail sales are bearish for the bond market but favourable for stocks, especially for retail stocks. Slow retail sales may trigger a bond market rally, but they are likely to be negative for the stock market.

Interest Rate Risk

 Let us say you buy a $10,000 bond with a 10% interest rate that pays you $1000 each year until maturity. Can you sell your bond before maturity to an investor for the $10,000 you paid for it? The answer is not always, and this is why; you don’t own a $10000 bond as much as you own a security that pays you an interest of $1000 a year.

The annual interest payment and current interest rates on any given day, in a large way, determine what the bond is worth. Assume that after you buy this $10,000 bond, interest rates drop from 10% to 8%.

However, no need to worry as your investment was locked in at 10%, so you will still earn an annual $1000 dollars. But let’s say another investor wants to buy a bond that will earn them $1000 a year; using the new interest rate of 8%, they will have to invest $12500. That means your $10,000 bond could be worth $12,500 if you choose to sell it; that is a $2500 gain.

But what if interest rates increased to 12%? A new investor will have to invest $8,333 in order to get an annual interest of $1000. This means that your $10,000 is almost $1700 less than what you paid.

Factors That Influence Interest Rate Risk

Bonds with low coupon rates are much more sensitive to changes in market yield than bonds with higher coupon rates. If a bond or debt instrument has a lower yield to maturity, its price will be much more volatile. The less sensitive the bond price, the higher the yield to maturity.

Bond prices and their yields are inversely related. As a result, when an interest rate rises, the price of bonds decreases or drops to a discount, and when an interest rate decreases, the price of bonds increases or is considered to be at a premium. Market fluctuations are an interest rate risk that must be taken into consideration when investing.

A bond will change significantly more in response to an increase in interest rates than a decrease of the same amount. This means that a bond has a greater chance of losing value overall than it does of increasing it or selling it for more profit. A bond or debt instrument is more susceptible to changes in interest rates the longer its maturity. Bond prices fluctuate less and less due to changes in the market as maturity approaches. As a result, a security with a shorter term has a lower interest rate risk.

As interest rates go up, the value of bonds goes down, and as interest rates go down, the value of bonds goes up. You can buy bonds at various maturities. The longer the maturity, the greater the interest rate risk. Short-term bonds do not fluctuate as much in price, given interest rate changes. The longer the bond, the greater the fluctuation in price. At maturity, the investor receives the base value of the bond and has received interest payments along that period of maturity.

Remaining Fluid To Mitigate Risks

By purchasing bonds with varying durations, as well as by hedging fixed-income investments with interest rate swaps, options, or other interest rate derivatives, interest rate risk can be reduced. Interest rate risk can be controlled through hedging or diversification techniques that shorten the duration of a portfolio or neutralize the impact of rate changes.

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