Rate Level Risk

Rate level risk refers to the fact that the value of an existing fixed income security typically falls if market interest rates increase above its coupon. Interest rate risk is one of four main factors affecting bond prices and typically increases with duration, a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates, stated as a number of years.

When a government or business issue fixed-income securities, the price and coupon are set by the issuer to be competitive within the current rate environment. Bonds will be offered at prices based on term structure and corresponding rates across the current yield curve. As interest rates vary going forward, prices of existing bonds will fluctuate; when interest rates increase, bond prices fall and vice versa.

When interest rates fall, holders of bonds and other fixed-income securities will typically see the value of their holding increase, even though the coupon rate is fixed. They may be able to sell their bond for a higher price than they paid for it. However, when rates increase, the value of a bond or portfolio of bonds that have been issued at correspondingly lower rates will decrease. This will be readily apparent in the daily pricing of bond mutual funds. For example, during a period when longer-term rates are rising, a bond portfolio that has a concentration in longer-term bonds will see its value drop.

Investors who own individual bonds can hold their bonds to maturity, (unless the bond has a call feature and is called) and receive the full return that the bond originally offered, barring a default. This assumes that the investor is comfortable with earning less than what may be available in the current market. For managers of large bond portfolios, rising rate levels have a significant effect on the value of the portfolio and the ability of the manager to attract and retain investors. For this reason, professional bond managers typically trade more frequently than individual bond holders in order to produce competitive pricing and yields for the portfolio.