During the last few weeks, we’ve been doing an article series on types of risk (you can find those articles here: The Risk of Losing Money, The Risk of Inflation, Drawdown Down Risk). This week we’ll be wrapping up that series by talking about interest rate risk. Interest rate risk is arguably one of the hardest risks to understand but is also really crucial that we understand what it is when it comes to the financial markets. Because interest rate risk has to do with bonds, let’s take a quick moment to brush up on bonds.
Despite their complexity, bonds add incredible value to our economy. You can think of bonds like mini loans. When you own stock in a company (such as shares of AAPL, or GOOG) you own a tiny sliver of that company and participate in the monetary growth that it experiences. When you own a bond, you own a tiny loan to that company. Why are bonds important? Consider your mortgage. Without your mortgage, you wouldn’t be able to afford a home, much like a large portion of the population. Luckily for you, someone was willing to loan you the money upfront so that you could purchase your home with the agreement that over time you would pay that entity back. When you buy a bond, you are participating in a similar transaction except that now you are the “bank.” You are, in essence, making a tiny loan to a company which, when coupled together with all the other tiny loans they’re receiving from all the other bondholders, allows them to grow their business with the agreement that they will slowly pay you back over time. Just like you have to pay interest on your mortgage, the company is also required to pay interest to you as compensation for the use of borrowing your money. This is where interest rate risk comes in.
For simplicities sake, let’s say that your bond – your tiny loan, has a fixed interest rate (bonds can come in all shapes and sizes, but it’s easier to understand if we assume a fixed rate like that of most mortgages). This fixed interest rate results in the company paying you a fixed amount over time; but what if you can get a higher interest rate elsewhere? Let’s say that at the beginning of this year you bought a bond that pays 3%, but several months later that same bond is now offering to pay 4% to borrow your money. You are stuck making 3% when you could be making 4%. This is the basic foundation of interest rate risk. As rates rise, your bond is worth less in the marketplace because it’s not paying as much in interest as you could get elsewhere. Conversely, if rates drop, your bond is suddenly worth more because you have locked in a higher rate than you would be able to find in the marketplace.
Now that we’ve realized the relationship between interest rates and bonds (high rates = less valuable bonds, lower rates = more valuable bonds), you may be remembering all of the hype in the news over the last year regarding the potential hike in interest rates. You may be thinking that a hike in interest rates would cause bond prices to fall and in a sense you are correct, but there’s a crucial aspect of the markets that it’s always important to keep in mind – markets respond to expectations. The markets won’t wait for the interest rate hike to occur before they respond. Markets respond as news unfolds and helps mold their expectations. This is part of the reason why the markets have been frothy recently. As information is made available about when the Fed may raise rates or by how much, the market responds immediately. While the Fed may likely raise rates in December, the market won’t wait until December to react, it will react as soon as the news breaks because it wants to be ahead of the game when it comes to managing things like interest rate risk.
If you have any questions regarding the different types of risk or would like to know more about how certain risks apply to you, please don’t hesitate to contact us. We’re happy to chat.