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I understand the concept of the interest rate risk (bonds lose value as the discount rate increases). However, if an investor only cares about how much money he will have at retirement and he wants a growth rate of 4%, he then buys a bond with a yield of 4%. Therefore, he just locked in a growth rate of 4%. Even if the interest rate rises in the future, why should he be concerned, since he has locked in a rate that he wanted?

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  • Your example clearly showed that an investor cared about interest rate risk by buying a bond that matures on the day of retirement (say a 20 year bond). 15 years later, the bond matures within 5 years, and the interest rate risk is lowered, without your intervention.
    – base64
    Aug 22 '15 at 15:50
  • What if he buys a bond fund instead of a bond? In that case, there can be changes in the fund's Net Asset Value that would impact returns.
    – JB King
    Aug 22 '15 at 16:06
  • Yes the yield is fixed but the bond price fluctuates if interest rate changes. Supposedly you bought a bond at a premium because low interest rates and then the government increased the rates. So if you are holding a 30 year bond you will be worried that others will buy at a lower price and will have a greater yield then you. And if you wanted to sell the bond before maturity you might need to sell at a capital loss.
    – DumbCoder
    Aug 22 '15 at 18:05
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    I.N.F.L.A.T.I.O.N
    – oldergod
    Aug 22 '15 at 23:44
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He didn't lock in a growth rate of 4%. He locked in a yield of 4%. That's the amount the bond pays in interest on his original investment each year. If he just spends that money the bond will continue to pay 4% each year, but there's no growth. In order to get growth he has to reinvest the interest as it comes in; if he puts it into bonds, the return on that new money, and hence the growth, depends on the prevailing interest rate at the time that the interest is paid. That interest rate can be higher or lower than the original 4%; there's no connection between the two.

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Some investors worry about interest rate risk because they

  1. Do not intend to hold a bond till maturity
  2. Want maximum return available in the bond market

Additional reason is margin trading which is borrowing money to invest in capital markets. Since margin trading includes minimum margin requirements and maintenance margin to protect lender "such as a broker" , a decrease in the value of bonds might trigger a threat of a margin call

There are other reasons why investors care about interest rate risk such as spread trade investors who benefit from difference in short term/ long term interest rates. Such investors borrow short term loans -which enables them to pay low interest- and lend long term loans - which enables them to gain high interest-. Any disturbance between the interest rate spread between short term and long term bonds might affect investor's profit and might even lead to losses.

In summary , it all depends on you investment objective and financial condition. You should consult with your financial adviser to help plan for your financial goals.

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Very rarely would an investor be happy with a 4% yield independent of anything else that might happen in the future. For example, if in 3 years for some reason or other inflation explodes and 30 year bond yields go up to 15% across the board, they would be kicking themselves for having locked it up for 30 years at 4%.

However, if instead of doing that the investor put their money in a 3 year bond at 3% say, they would have the opportunity to reinvest in the new rate environment, which might offer higher or lower yields.

This eventually leads fixed income investors to have a bond portfolio in which they manage the average maturity of their bond portfolio to be somewhere between the two extremes of investing it all in super short term/ low yield money market rates vs. super long term bonds.

As they constantly monitor and manage their maturing investments, it inevitably leads them to managing interest rate risk as they decide where to reinvest their incremental coupons by looking at the shape of the yield curve at the time and determining what kind of risk/reward tradeoffs they would have to make.

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If you buy a long term bond with long term fixed interest rate, and then the interest rates increase, your bond is worth less. That's not a problem, because over the years the value of the bond will go back to its nominal value. If you have a bond that doesn't pay out annually but increases its value every year, you will get exactly the amount of cash when it pays out that you expected.

The problem is that if for 20 years interest rates were 8% while your bond only paid 4%, then you will have such an amount of inflation that the cash you get is worth much less than you hoped. You may have hoped that your bond would be worth "one year average salary", but it may be only worth "six months of average salary", even if the dollar amount is exactly what you expected.

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