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I'm looking to develop a fixed-income account of bonds and dividend-paying equities. I've heard that bonds are susceptible to interest rate risk, but I don't really understand what that means.

What is interest rate risk, and what techniques do I use to minimize it?

Should I even be concerned about it if I plan to hold onto the same assets for a long time?

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3 Answers

up vote 1 down vote accepted

If you own a bond and the interest rate goes up, the price on your bond goes down. You're stuck with a loss of principal (if you sell), or receiving a lower rate than what is available in the market.

See also Bond Ladder.

I would personally invest in a bond ETF before looking at individual bonds. That will mitigate a number of risks associated with bonds.

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I like the bond ladder concept. If I understand it correctly, letting the bond come to maturity is equivalent to selling the bond at its original price. Therefore, staggering maturity dates protects me from market fluctuation, as I can just wait for the next bond to mature to get cash if I need it. Is this at all correct? –  Mashmagar Aug 5 '10 at 12:47
A bond fund / bond ETF is fine if you just want "exposure to the bond market" and does reduce certain risks, but it changes (possibly increases) interest rate risk, since it always maintains a certain average time to maturity. With an individual bond, as it gets closer to maturity, the interest rate risk will be reduced. This is good if you know you're going to spend the money at a certain date (e.g. a college education fund) and don't want to lose your money to a rate change at the last minute. –  fennec Dec 6 '10 at 16:22
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I'll just expand a bit on the initially somewhat unintuitive statement that when rates go up, values go down:

I have a long-term bond I bought last year with face value $100 and fixed interest rate 5%: every year it pays the holder $5. The issuer is now seen as more risky than they were last year, and now people will only buy new bonds if they pay 10%.

My friend John comes along, and he has the option of either buying a newly issued bond or buying the bond from me. If he spends $100 on the 10% bond, he will get back $10 per year. So he would be a fool to pay me $100 for an equivalent bond that will pay only $5 per year, but if I accepted only $50 he should be indifferent between the two.

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The interest rate is also called the coupon - since it's like the difference between the price you pay and the money you actually get in the end. So... if everyone buying wants big coupons, you (as a seller) are going to end up with less. –  fennec Dec 6 '10 at 16:25
@fennec - Your interpretation of "coupon" is maybe a useful mnemonic, but see the wikipedia article: "The origin of the expression 'coupon' is that bonds were historically issued as bearer certificates, so that possession of the certificate was conclusive proof of ownership." –  bstpierre Dec 6 '10 at 20:32
Also look up "Zero Coupon Bond" for a type of bond that trades at a discount to the maturity value but does not have a coupon associated with it. –  bstpierre Dec 6 '10 at 20:33
Mmmmmmk. Noted. –  fennec Dec 6 '10 at 21:31
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If you buy a bond and hold it until maturity, then you really wouldn't feel any interest-rate risk.

The risk only becomes real if you hold a bond which you intend to sell before it matures.

This is why the yield curve slopes upward, generally: to encourage you to buy bonds which have a longer maturity, even if you plan to get your money out earlier. In this sense it is a type of risk premium.

A bit more on that.

Suppose you want to invest your savings for a couple of years, and see that you could buy government bonds with a maturity of 2 years which have an implied yield of 2%. This is appealing, since you will definitely (barring a government default) have your savings back intact at the end of year 2.

Now your broker tells you that the 10-year government bonds are yielding 3%, "so why don't you buy the 10-year bond, get the extra 1% interest for a couple of years, then sell the bonds back into the market?" he suggests.

Now you need to have the 'interest-rate risk here!' alarm bells ringing.

Let's walk through the calculations. If you invest $100 in the 2-year bond, you'll get a couple of coupons and your $100 back at the end of 2 years: say $104 in total cash.

Alternatively, if you invest your $100 in the 10-year bond, then at the end of year 2 you will have also had a couple of coupons, but you won't get your money back. Instead, you'll be holding an 8-year government bond.

Cutting to the chase, if interest rates move dramatically higher over the next 2 years, then the 8-year government bond will lose value, so although you had higher coupons from the 10-year bond, you probably won't be able to sell the 8-year bond back to the market at a price near $100. So your cash position will be worse than $104 - you should have not been distracted by the higher coupon of the 10-year bond.

In summary

Interest-rate risk only matters if you do not hold to maturity.

If you don't plan to hold a bond to maturity, then you need to be comfortable that the extra yield you get is enough that you feel it comfortably compensates you for the risk that interest rates move upward and damage the price at which you would sell your bond when you want to take your money out of the investment.

(I covered this in my blog, btw: www.fermatslastspreadsheet.com)

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