Interest rate Risk

Interest rate risk is concerned with a decline in the price of a bond or a portfolio of bonds due to an increase in market rates. As rates increase, bond prices decline and vice versa.

The features of a bond affect the bond’s interest rate in the following ways:

•Maturity – The longer the maturity of the bond, the more sensitive it is to interest rate movements. The reason for this effect is that more cash flows will be affected over a longer period of time.

•Coupon Rates – Lower coupon rates are more sensitive to interest rates. Why? If your bond is paying 4% and rates are in an upward swing, the difference in the market yield and your yield will continue to widen, which will push your bond values down.

•Embedded Options – As interest rates decline the value of the option becomes more valuable to the issuing company. The price will increase as rates decline but will be held at the call or redemption price. This is because as rates decline it will become more likely that the issuer will call the bonds and that the holder will only receive the call price and not a true market price. Likewise, when rates rise the price will not drop as much because the option will maintain some sort of value when compared to a bond with no options.

Reference: http://www.investopedia.com/exam-guide/cfa-level-1/fixed-income-investments/interest-rate-risk.asp#axzz1giDcOnzS

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Inflation Risk

Also known as Purchasing Power Risk, this risk arises from the decline in value of securities cash flow due to inflation, which is measured in terms of purchasing power.

Here’s how it works:

You buy a bond with a coupon rate of 4%. The inflation rate is at 2%. Even though you are earning 4% on your money, inflation is chipping 2% of it away only leaving you with 2% of your money or purchase power, which you can use when you receive your payments.

Only Inflation Protection Bonds such as TIPS offer protection against this risk. Floaters help reduce this risk because of the resetting of the interest rates. All other bonds expose the investor to this risk because the interest rate is fixed for the life of the bond.

Reference: http://www.investopedia.com/exam-guide/cfa-level-1/fixed-income-investments/inflation-risk.asp

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