What is Interest Rate Risk?
Interest rate risk is the risk that rising interest rates will cause bond prices to fall. Bond prices and interest rates move inversely - when rates rise by 1%, a bond with 10-year duration loses approximately 10% of its value. In 2022, the US Federal Reserve raised rates from near 0% to over 4%, causing the Bloomberg US Aggregate Bond Index to lose about 13%, its worst year on record. Short-term bonds with 1-3 year durations lost only 3-5% during the same period.
Duration as a Measure
Duration quantifies interest rate sensitivity. A bond with a duration of 5 years will lose approximately 5% in value for every 1% increase in interest rates. Long-term government bonds (20-30 year maturity) have durations of 15-20 years, making them extremely sensitive to rate changes. Short-term bonds (1-3 years) have durations of 1-2 years and are far more stable. The Bank of Japan's yield curve control policy kept 10-year JGB yields near 0% for years, compressing interest rate risk until the policy was adjusted.
Key Considerations
Investors can manage interest rate risk by matching bond duration to their investment horizon. If you need the money in 5 years, a bond fund with 5-year duration will deliver approximately the stated yield regardless of rate movements, because price losses are offset by reinvestment at higher rates. Bond laddering - spreading investments across multiple maturities - provides a practical way to reduce interest rate risk while maintaining steady income.