What is Interest rate risk?
The risk that after you commit to lending your money out for a significant number of years at a fixed rate, interest rates in the economy rise. Had you waited a while before making your loan, you would have been able to lock in a higher rate of interest.
How this risk plays out in the real world
Sep 04, 2014: ECB cuts rates to ward off euro zone deflation threat
Aug 22, 2014: Fed Chief Sees Not Enough Data to Raise Rates
Sep 13, 2012: Fed to launch QE3 of $40 billion MBS each month
Sep 20, 2012: Sorry, savers: Interest rates set record lows
Connection to other risks
Interest rate risk is related to Inflation risk. If inflation is rising or expected to rise, people won’t want to earn a rate of return that is less than the rate at which prices are going up. So as inflation rises, investors will demand higher and higher rates of interest.
Read the glossary definition of a Bond.
How investors can manage Interest rate risk
- Buy TIPS bonds, a special type of bond issued by the United States government that compensates for inflation
- Buy floating rate bonds whose rate will rise as interest rates rise
- Don’t buy long-term bonds or otherwise loan your money out at a fixed rate for a long period of time when interest rates are at historical lows because when they begin to rise, the rate of interest you are earning will be worse by comparison.
A final word on
The Federal Reserve Bank held interest rates at historical lows for several years after the Great Recession of 2008-2009 to give the economy ample opportunity to grow. In late 2015, it finally believed the economy was strong enough to withstand gradual increases in interest rates toward normal levels.