Takeaways
- Interest rate risk is the risk of your investments declining with changes in interest rates.
- Interest rates are affected by financial policy decisions from the Federal Reserve.
- Bond prices fall as interest rates rise and increase as interest rates fall.
- Maturity risk premium is the added return investors expect for longer-term securities.
- Interest rate risk affects bonds, certificates of deposits, savings accounts, and more.
What Is Interest Rate Risk?
Interest rate risk refers to the potential for losses resulting from changes in interest rates. When interest rates fluctuate, they directly impact the value of financial products, especially fixed-income securities like bonds.
The most significant impact occurs because of the relationship between bond prices and interest rates. When interest rates rise, existing bonds with lower fixed coupon rates become less appealing, causing their prices to drop. Conversely, when interest rates fall, the prices of existing bonds rise because their fixed payments become more valuable than newly issued bonds.
Interest rate risk is a significant concern for those investing heavily in long-term fixed-income securities. Banks, pension funds, and insurance companies are also highly exposed, as interest rate risk affects profit margins and liabilities.
Read More: 7 Different Types of Bonds
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Example of Interest Rate Risk
Suppose you own a bond with a fixed annual interest rate of 3%. Now imagine that the Federal Reserve suddenly raised the federal funds rate from 3% to 5%.
New bonds that now pay 5% are being issued, making you’re the 3% bonds you hold less attractive to prospective investors. As a result, your bond's value (price) decreases because no one wants to buy it unless they can get a discount.
On the other hand, if market interest rates drop to 2%, your 3% bond becomes more valuable since it pays a higher interest rate than newly issued bonds. In this case, the price of your bond goes up.
This simple example illustrates how interest rate changes can directly impact the value of your investments.
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7 Investments Impacted by Interest Rates
- Bonds: Fluctuation in bond prices is the classic example of interest rate risks. Whether you are investing in a corporate or high-yielding bond, interest rates directly impact the cost of your investment. (Read more about the 7 Different Types of Bonds).
- Certificates of Deposits: CDs pay a fixed interest rate to investors. Because certificates of deposits can have terms ranging from 3 months to over 5 years, the degree of interest rate risk exposure is greeted by more long-term maturities. (Read more about our picks for the Best Certificates of Deposits).
- High-Yield Online Savings Accounts: While the cash value of your holdings doesn’t fall in a high-yield online savings account with changing interest rates, the attractiveness of stashing your cash here does. Funds will flow into high-yielding accounts as interest rates rise and out when interest rates decline. (Read about our picks for the Best High-Yield Savings Accounts).
- High-Yield Online Checking Accounts: Holding your cash in a high-yield savings account becomes in vogue when interest rates rise, and account holders can generate more interest income. When interest rates are low, investors flock to higher-returning assets. (Read more about the 6 Steps to Open a Checking Account).
- Real Estate: Real estate investments can fluctuate based on interest rates. If investors invest in REITs or directly in properties, they can refinance their mortgage to lower rates, boosting returns. Conversely, if interest rates rise, their rents need to keep up with other fixed-income securities. (Read more about 5 Ways to Get Started Investing in Real Estate).
- Dividend-Paying Stocks: Stocks generally respond inversely to interest rates. As interest rates rise, the value of dividend-paying stocks falls unless these companies boost their dividend payments to keep pace with interest rates. (Read more about our picks for the Best Online Stock Brokerage Accounts).
- Treasury Inflation Protected Securities (TIPS): TIPS are long-term investments issued by the U.S. Treasury that help investors hedge against inflation and rising interest prices. These investments have a floating part of their interest payment tied to the fluctuating Consumer Price Index (CPI) value. As the CPI rises, they earn more, and as inflation wanes, they earn less. (Read more about the 26 Ways to Beat Inflation).
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What Is the Maturity Risk Premium?
The maturity risk premium is an additional yield that investors demand for holding long-term bonds compared to short-term bonds. This premium compensates you for the increasing uncertainty and risks of longer maturities.
Long-term bonds, like U.S. Treasury Bonds, are more exposed to fluctuations in interest rates, as changes can have a more significant cumulative impact over time. For instance, a 30-year bond is more sensitive to interest rate movements than a 5-year bond—the maturity risk premium accounts for this heightened exposure.
Investors typically see higher yields on long-term than short-term bonds, reflecting this premium. However, the trade-off is that holding long-term bonds exposes investors to higher interest rate risk.
Read More: Best 9 Low-Risk Investments of 2025
Bond Price Sensitivity
Bond price sensitivity measures how much a bond’s price changes in response to fluctuations in interest rates. This sensitivity is primarily determined by a bond’s duration, which reflects its average time to maturity, weighted by the present value of cash flows.
Bonds with longer durations are more sensitive to interest rate changes. For example, if interest rates rise, a bond with a duration of 10 years will experience a more significant price drop than a bond with a duration of 1-3 years.
Diversification is a common strategy for mitigating interest rate risk. Holding a variety of fixed-income investments and bonds can help minimize the impact of interest rate changes on the total portfolio value.
Smart Summary
Interest rate risk is the risk associated with changes in prevailing interest rates impacting your investment’s value. Even with interest rate risk, bonds are considered a lower-risk investment than stocks. [1] However, all types of investments carry some degree of risk. A diverse investment portfolio can protect you against sudden changes in the interest rate and market conditions. Learn more about investing in the seven asset classes to boost your diversification.
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(1) U.S. Securities and Exchange Commission. Bonds. Last Accessed January 24, 2025.
