Fixed Income Risk: Interest Rate Risk and Credit Risk
Understanding the risks associated with fixed-income investments is crucial for any investor, especially those preparing for rigorous examinations like the CFA. This module delves into two primary risks: Interest Rate Risk and Credit Risk. Mastering these concepts will equip you to analyze bond portfolios and make informed investment decisions.
Interest Rate Risk
Interest rate risk is the potential for investment losses that arise from a change in interest rates. For fixed-income securities, this risk is particularly significant because bond prices have an inverse relationship with interest rates. When interest rates rise, the market value of existing bonds with lower coupon rates falls, and vice versa.
Bond prices and interest rates have an inverse relationship: when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.
Credit Risk
Credit risk, also known as default risk, is the risk that the issuer of a bond will be unable to make its promised interest payments or repay the principal amount at maturity. This risk is inherent in all debt instruments, as the issuer's financial health can deteriorate over time.
| Risk Type | Definition | Primary Impact | Mitigation Strategy |
|---|---|---|---|
| Interest Rate Risk | Potential loss due to changes in market interest rates. | Changes in bond prices. | Duration management, diversification, hedging (e.g., interest rate swaps). |
| Credit Risk | Potential loss due to issuer's inability to meet debt obligations. | Default on interest payments or principal repayment. | Credit analysis, diversification, investing in higher-rated bonds. |
Remember: A bond's yield to maturity (YTM) already incorporates expectations about future interest rates and the issuer's creditworthiness. However, unexpected changes in either can lead to price volatility.
Interplay Between Interest Rate and Credit Risk
It's important to recognize that these risks are not always independent. For instance, during an economic downturn, interest rates might fall (benefiting bond prices), but the risk of corporate defaults often increases (harming bond prices). Conversely, during periods of high inflation, interest rates may rise, increasing interest rate risk, while strong economic growth might reduce credit risk. Understanding this interplay is vital for a comprehensive risk assessment.
This diagram illustrates the inverse relationship between bond prices and interest rates. As interest rates (on the x-axis) increase, the price of a bond (on the y-axis) decreases. The steepness of this curve is determined by the bond's duration. A higher duration means a steeper downward slope, indicating greater price sensitivity to interest rate changes.
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Learning Resources
A comprehensive overview of interest rate risk, its causes, and its impact on fixed-income investments.
Explains credit risk, its components, and how it affects lenders and bondholders.
Official curriculum resources from the CFA Institute covering fixed-income topics, including various risks.
A clear video explanation of bond duration and its role in measuring interest rate risk.
An explanation from Moody's on how credit ratings are assigned and what they signify.
A lecture from a Coursera course that breaks down the risks and returns associated with fixed-income securities.
Khan Academy's accessible explanation of the fundamental relationship between interest rates and bond prices.
An article explaining credit spreads as compensation for taking on credit risk.
An official guide from S&P Global Ratings on how they assess and communicate creditworthiness.
Charles Schwab's educational content on various risks associated with fixed-income investments, including interest rate and credit risk.