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I was wondering why there is interest rate risk on a bond that a financial services firm has sold, besides default risk on the bond? As far as I know interest rate risk means the risk that is caused by the change of interest rate. However the interest rate of a bond is specified by the issuer when it is issued and fixed ever since , so how the change of interest rate in the future will cause risk? Will this interest rate risk affect the issuer of the bond, or the buyer of the bond, or both?

Thanks and regards!

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It doesn't matter much if you intend to hold the bond to maturity. In that case you just collect your coupons and principal at the end (assuming no default). However, if you decide to sell before maturity the price you sell the bond at depends on how interest rates move as your bond will need to stay roughly in line with prevailing rates for similar securities. For example;

You have a $1000 face bond paying 7% and maturing in 5 yrs issued by a financial institution. If current US Treasury Bonds/Notes of similar maturity are paying 4%, your bond is trading ~ 300 bps (basis points) over treasuries. If the interest rate on treasuries goes to 6%, it means the price of the bond must go down to increase the return on the treasury bonds. This means your financial institution bonds must also go down in price to maintain that 300 bps spread over treasuries.

The term interest rate risk is a bit inaccurate. It really refers to price risk, as in, what will happen to the price of my bond if market interest rates change.

  • Thanks! Does change in treasury interest rate pose a risk to both holder and issuer of a coporate bond? – Tim Dec 10 '11 at 16:42
  • Depends on the structure of the bond. If it's a fixed rate bond, the issuer has no IR risk, as the coupon is set at issuance. If it's variable, then there is risk as the coupon rate is affected by IR changes. For the buyer, there is no IR risk if held to maturity, however as you never know if you will be able to hold to maturity, there is some IR risk as the bonds price will be affected by changes in rates. – screechOwl Dec 10 '11 at 16:55
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    I would also add that the real danger to a bond holder in the short term due to interest risk is margin requirements if those bonds are held in a margined account. A great example of this would be the recent collapse of MF Global because even though none of the bonds and govt debt they held actually defaulted, the interest rates in those countries pushed prices down so much that MF Global couldn't finance the margin requirements to keep the positions. – Matt Phillips Dec 12 '11 at 15:35

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