Imagine you’re buying a bond. A bond is basically like lending money to a company or a government. They promise to pay you back your original money (the “principal”) on a specific date, and in the meantime, they pay you a fixed amount of “interest” regularly (like every year).
Interest rate risk is simply the chance that the value of your bond will go up or down because the general “interest rates” in the market change.
Think of “general interest rates” as the going rate for new loans out in the world today.
Real-Life Example: You Buy a Bond
Let’s say it’s June 14, 2025. You buy a brand new bond from “Acme Company.”
- Bond Details: You lend Acme Company ₹10,000. They promise to pay you 5% interest every year (that’s ₹500), and they’ll pay back your ₹10,000 in 5 years.
Now, let’s see how interest rate risk plays out:
Scenario 1: General Interest Rates in the Market Go Up
- It’s now June 14, 2026. The economy is booming, and the “going rate” for new bonds (and new loans in general) has risen to 7%.
- Your Bond’s Problem: You’re still only getting 5% interest (₹500) from your Acme bond. But anyone buying a new bond today can get 7% interest (₹700) for lending the same ₹10,000.
- The Risk: If you wanted to sell your 5% Acme bond today, no one would pay you the full ₹10,000 for it. Why would they, when they can buy a new bond and get 7%? You’d have to lower the price of your bond to make it attractive. You might only be able to sell it for, say, ₹9,500.
- This ₹500 loss in value is your interest rate risk (specifically, “price risk”). The bond’s market value went down because general interest rates went up.
Scenario 2: General Interest Rates in the Market Go Down
- It’s now June 14, 2026. The economy is slowing, and the “going rate” for new bonds has fallen to 3%.
- Your Bond’s Benefit: You’re still getting 5% interest (₹500) from your Acme bond. But anyone buying a new bond today can only get 3% interest (₹300) for lending the same ₹10,000.
- The Advantage: If you wanted to sell your 5% Acme bond today, it would be very attractive! Everyone wants that higher 5% interest. You could likely sell it for more than ₹10,000 (maybe ₹10,500) because it’s a better deal than anything new on the market.
- In this scenario, interest rate changes helped your bond’s value.
Another Aspect: Reinvestment Risk
- Let’s say your 5-year Acme bond matures on June 14, 2030, and Acme Company pays you back your original ₹10,000.
- If, at that time, general interest rates have fallen to 3%, then when you go to buy a new bond with your ₹10,000, you’ll only be able to get 3% interest. You’ll earn less money than you did before.
- This is “reinvestment risk” – the risk that you’ll have to put your money into lower-paying bonds (or other investments) in the future.
Simple Summary:
- If you own a bond:
- Interest rates go UP: The value of your existing bond generally goes DOWN. (Bad for you if you need to sell it).
- Interest rates go DOWN: The value of your existing bond generally goes UP. (Good for you if you need to sell it).
- This up-and-down movement in your bond’s value due to changing market interest rates is what “interest rate risk” is all about.
