Got Bonds? Understanding Interest Rate and Reinvestment Risks

Key Takeaways

New investors quickly learn that investing in bonds may help diversify portfolios because bonds are typically less volatile than stocks. And bonds may offer regular income, regardless of the interest rate environment.

But investing in bonds involves risks, including interest rate and reinvestment risks. These risks can also contribute to periods of volatility in bond prices. Understanding that volatility is key to managing bond investments effectively.

Let’s dive into interest rate risk, including how rate fluctuations can impact your bond portfolio, the connection between interest rate and reinvestment risk, ways to help manage these risks and why actively managed bond funds may be a solution.

What Is Interest Rate Risk?

Interest rate risk refers to the possibility that a bond's value will decline due to rising interest rates.

Interest rates and bond prices move in opposite directions. When market interest rates rise, newly issued bonds will offer coupons and yields that align with prevailing interest rates. However, prices on existing bonds generally decline because their yields don’t reflect the higher level of interest rates now available in the market.

Conversely, as interest rates fall, prices of older bonds with higher coupons increase amid rising investor demand for the higher-yielding securities.

Note: If you hold bonds to maturity, interest rate risk is generally less of an issue because you continue to receive scheduled interest payments and the bond’s face value at maturity (provided the issuer does not default).

Review bond fund basics.

How Changing Interest Rates Impact Bond Investments

Current interest rates help determine a new bond’s coupon—that is, how much income you’ll receive from the bond’s regular interest payments. A bond’s coupon is the rate of interest a bond pays annually. So, a $1,000 bond with a 3% fixed coupon would pay $30 in annual interest.

While bond issuers set the coupon when they issue a bond, its current yield—the bond’s coupon divided by the current market price—will change as market prices change.

If interest rates rise, prices on existing bonds typically fall. Bonds continue to pay interest even as their prices fluctuate, but the near-term total return (price change and yield) may decline.

Example of Interest Rate Risk Impacting Investors

Consider a scenario in which you buy a bond at a par value of $1,000 with a fixed coupon rate of 3%.

• If market interest rates rise to 4%, newly issued fixed-rate bonds may feature a 4% coupon.

• You will have trouble selling your existing bond in the secondary market because newer bonds can provide more attractive yields.

• The lower demand will trigger lower prices, and the market value of your 3% coupon bond will likely drop below your $1,000 purchase price. If you sell the bond before it matures, you may incur a loss of principal.

What Is Bond Duration, and How Does It Affect Interest Rate Sensitivity?

Duration, expressed in years (but not the same as a bond’s maturity), is a key measure of a bond fund’s sensitivity to interest rate changes. Although the prices of all bonds are affected by interest rate fluctuations, the magnitude of the change varies.

The longer the duration, the more a bond’s value will rise or fall with changes in market interest rates.

How to Use Bond Duration to Help Manage Interest Rate Risk

As an investor, you can’t eliminate interest rate risk, but you can seek to mitigate it by looking at your mix of longer- and shorter-duration bonds.

If you think interest rates have peaked and will likely move lower:

Focus on Longer-Duration Bonds

Investing in longer-duration, higher-yielding bonds or funds when interest rates are high offers price appreciation potential if interest rates fall.

If you think interest rates have not peaked and will continue to rise:

Focus on Shorter-Duration Bonds

Investing in shorter-duration bonds or funds when interest rates rise may help limit price declines because their prices are less sensitive to interest rate changes.

What Is Reinvestment Risk and How Does the Fed Affect It?

Reinvestment risk is the inability to reinvest money into securities that will earn the same or higher rates as your original investment.

When it seems that the Federal Reserve (Fed) might cut interest rates, investors may face growing reinvestment risk. Yields on short-maturity bonds and cash equivalents tend to move in sync with the federal funds target rate. So, if the Fed cuts rates, yields on savings accounts, Treasury bills, certificates of deposit and other similar investments likely will fall too.

Going back to our bond example with the 3% fixed coupon, what if interest rates fell to 2%?

You would first be a happy investor because your bond’s price likely would rise above your $1,000 purchase price—as interest rates fall, bond prices generally rise. The 3% bond pays more than newly issued bonds at 2%.

However, suppose your bond matures and you want to purchase another bond. You would reinvest your principal in a lower interest rate environment, and your new bond investments will not earn as much as before.

Reinvestment risk is heightened when the yield curve is inverted; that is when shorter-maturity yields are higher than longer-maturity yields. Learn more about what the shape of the yield curve can tell investors.

Having some longer-maturity bonds or bond funds may help mitigate reinvestment risk in this situation. Adding duration with longer-maturity holdings may help generate capital appreciation when rates fall. However, if rates have not yet peaked, this move would increase your interest rate risk.

As Rates Move, Risk Exposures Change

How Can You Help Manage Bond Risks?

Diversify Holdings With Higher-Yielding Bonds

Corporate bonds or mortgage-backed bonds are typically less sensitive to interest rate changes than Treasuries and thus can diversify high-quality bond portfolios. But keep in mind that these bonds are typically riskier than Treasuries and add exposure to another risk: credit risk.

Spread Out Bond Maturities With Bond Laddering

Bond laddering is a strategic approach that many active managers of diversified fixed-income portfolios use to manage bond risks. It involves having bonds with different maturities and smaller amounts to reinvest over time.

For instance, if you have $50,000 to invest, you might divide that into equal parts and put $10,000 each in bonds that mature in one, five, 10, 20 and 30 years. When the one-year bond matures, you can use the proceeds to buy a new five-year bond at the prevailing market rate.

• If interest rates have risen, you have the opportunity to buy a bond offering a higher yield.

• If interest rates have fallen, you may still buy a new five-year bond to keep the bond ladder in place. However, the other bonds in the portfolio may continue to yield returns more elevated than the current market rates for new bonds.

Don’t Let Bond Risks Overshadow Their Potential Value in Portfolios

Interest rate and reinvestment risks are part of bond investing, but they don’t diminish the potential value of a thoughtfully constructed bond allocation. A diversified mix of maturities and bond types—whether selected individually or through active bond funds, ETFs or asset allocation portfolios—can help you adapt. With an approach matched to your goals and time horizon, a bond allocation can serve as a valuable portfolio building block.