How does interest rate risk affect a bond’s value?
Interest rate risk is the possibility that a bond’s price will change due to a change in prevailing interest rates. Bond prices are closely related to interest rates. When interest rates go up, most bond prices go down. When interest rates go down, bond prices go up. Interest rate risk is commonly measured by a bond’s duration. Duration is a measure of the sensitivity of a bond’s price to interest rate movements. A bond’s duration depends heavily on the remaining maturity of the bond and is often expressed in years. In general, the longer a bond’s remaining maturity, the higher its duration will be and the more its price will tend to fluctuate as interest rates change. For example, a bond with 20 years left to maturity will have a higher duration than an otherwise equivalent bond with 10 years left to maturity. Consequently, a rise in interest rates will cause a larger drop in price for the bond with the higher duration. However, while longer-term bonds tend to fluctuate in value more
