Bonds and Interest Rate Risk

Interest rate risk can simply be described as the propensity of change in interest rates. Normally, rich investors will buy bonds to protect their capital from the ravages of inflation. This is one of the other major risks for investors--what's known as inflation risk. As inflation increases, the value and purchasing power of the dollar will decrease. In order to preserve capital over time, rich people invest in bonds. Imagine if the inflation, the rate of growth in the money supply, were equal to the coupon rate, the rate a bond pays investors. What this would mean is that, over time, the capital invested in the bonds would preserve its purchasing power. In other words, that sum of capital would grow large enough to maintain its original purchasing power. 

Inflation is normally perceived to be no more than 3 percent in the modern U.S. economy. Currently, the inflation rate in the U.S is measured at 2 percent per annum--translation: a normal basket of goods that is purchased on a daily basis is becoming 2 percent more expensive annually. Meanwhile, the average interest rate for 5-year certificates of deposit (CDs) is currently around 2.5 to 3.0 percent. Certificates of deposit are generally risk-free time deposits. Since inflation and interest rates are lower than average in 2010, we are considered to be in a low-interest-rate, low-inflation environment. So long as interest rates stay the same, this 5-year CD will protect the capital and grow it well enough to outpace the rate of inflation over time. However, what happens with the change in interest rates? Since the rate paid to these investors is constant, any change in interest rates will adversely effect the capital sum of money when all is said and done by the end of 5 years. Let's look at what would happen if interest rates had two different scenarios: one with sinking interest rates and one with rising interest rates.  

Period of Sinking Interest Rates

A period of falling interest rates would be beneficial for this 5-year CD and even more so for bond investors. Because a bond can be traded before its maturity, when the interest rates sink lower and lower, the price of the bond, and the overall value of the capital invested, goes higher and higher. Therefore, there is no real risk in falling interest rates. However, volatility in interest rates can be risky even if they go higher. This volatility in interest rates poses a form of interest rate risk to bond investors. If this scenario is foreseeable, it would be best to invest in floating-rate bonds, which could possibly smooth out this apparent risk.

Period of Rising Interest Rates

The greatest risk, of course, is that interest rates will go up. Since the rate of the note or CD is locked until the maturity of its term, the risk is that the note will not pay the investor enough to keep up with the market outside.

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