Let's begin with a general definition of interest rate risk for fixed coupon bonds.
The coupon rate is set at the time of issuance and remains unchanged throughout the life of the bond.
The primary variable that fluctuates in the market is the bonds price.
To keep things simple, we will not address reinvestment risk here.
Let's also focus on government bonds here, which simplifies things by eliminating the impact of credit spreads.
When demand for a bond increases the clean price, which is the bonds price, excluding accrued interest rises.
This means investors now must pay more for the same future cash flows.
Effectively lowering the bonds yield the return on investment for investors already holding the bond.
A rise in the clean price doesn't just imply that new buyers will earn a lower return.
It also provides an opportunity to sell the bond at a profit.
For example, if an investor purchased the bond at a clean price of 100% and it now trades at 102%, they can sell it for an immediate 2% gain.
Therefore, a decline in yields typically benefits the holder of a plain vanilla coupon bond.
Conversely, when yields rise and bond prices fall, existing investors may experience market to market losses.
Most bond investors approach the market from the long side, meaning they hold long positions or none at all.
As a result, interest rate risk is usually defined from this perspective.
For these investors, interest rate risk refers to the potential for bond prices to decline when yields increase.
While understanding this basic relationship is important, investors need more than just intuition to make decisions.
Not all bonds react equally to changes in interest rates.
Some are more sensitive than others, even when credit risk is excluded.
To compare interest rate risk across different bonds, investors use tools, the most significant of which is the concept of interest rate sensitivity.
Interest rate sensitivity, often referred to as duration or more precisely rates.
Duration, indicates how much a bond's price will change, for a given movement in risk-free interest rates, ignoring other factors such as credit risk.
