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Posted: April 13th, 2023
Interest Rate Risks
Interest rate risk refers to the change in the price of a bond for a given change in yield to maturity. Bonds have interest rate risk, because the yield to maturity at a
given point in time changes with market interest rates.
Investors risk the default of the bond, the value of the payments relative to ination, the value of the payments’ reinvestment rates, and the payments over the time to
maturity.
Examples of different types of interest rate risks are:
Default risk: The bond issuer will not be able to repay the interest, the principle, or both.
Ination risk: The value of payments and the principle decline because of unanticipated ination.
Reinvestment risk: The value of the payment might earn a lower return than the original bond.
Maturity risk: Over time, more risks can occur to the payment stream of a bond.
Liquidity risk: This is the preference of investors to risk short-term versus long-term.
Investor perception on the risk of bonds will raise their desired return, the interest rate, resulting in falling bond prices. The consequent shift in investor holdings based
on risk from stocks to bonds or vice versa is called “ight to quality.”
Bonds are rated with respect to default risk. Third-party companies that are independent of the bond issuer rate the bonds’ default risk. Each of these companies uses
letters to rank the company. The conventions on the nancial markets use the company ratings to grade the debt.
Investment grade: The debt has a high rating.
Speculative (junk) grade: The debt has a low rating.
The higher the rating, the lower the default risk, and thus, the lower the interest rate. From a management point of view, this reduces cost of nancing. The lower risk is
preferred by some investors.
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