The main risk in holding a long-term bond in a rising interest rate scenario is interest rate risk, specifically a significant drop in the bond's market price. Because long-term bonds have higher duration, their prices are more sensitive to rising rates, meaning investors may face substantial capital losses if they sell before maturity.
Interest rates directly affect bond prices. When interest rates rise, bond prices fall; when rates drop, bond prices rise. This relationship, known as interest rate risk, means that if you sell a bond before it matures, you may receive more or less than its face value depending on current rates.
Long-term bonds are more sensitive to interest rate changes due to their greater duration. Bond prices fall when interest rates rise, and they rise when rates fall. Investors can hedge interest rate risk with derivatives like swaps and futures.
When interest rates rise, existing bonds paying lower interest rates become less attractive, typically causing their value to drop below their initial par value in the secondary market. (The regular interest payments remain unaffected.)
Rapid interest rate hikes can slow economic growth or trigger a recession. Central banks use interest rates to balance economic growth and inflation control. Quick rate increases can disrupt planning, discourage investment, and unsettle markets.
Higher borrowing costs
Rising rates tend to make borrowing more expensive for a business. That's because you'll have to pay a larger percentage of your loan back as interest.
Interest rate risk is the potential for investment losses that can be triggered by a move upward in the prevailing rates for new debt instruments. If interest rates rise, for instance, the value of a bond or other fixed-income investment in the secondary market will decline.
Rising interest rates can be good for bond investors as they can take advantage of the higher rates to boost their portfolios' long-term growth potential. For example, say a bond investor receives coupon payments from an existing bond holding, or one of their bond holdings matures.
Warren Buffett views bonds as a safe haven for cash, often recommending a 90/10 portfolio (90% S&P 500 index fund, 10% short-term government bonds) for average investors, while Berkshire Hathaway itself holds large amounts of U.S. Treasury bills for capital preservation and to earn competitive yields, especially when stocks are expensive. He favors short-term Treasuries (T-bills) due to low interest rate risk and high liquidity, using them to park cash while waiting for better stock opportunities, rather than as a primary growth engine.
Interest rate risk is a significant factor that investors must consider when investing in government bonds. Bonds are generally inversely proportional to interest rates, meaning that as interest rates rise, bond prices fall, and vice versa.
A higher-than-expected Treasury supply also increases the long-run equilibrium real interest rate as well as inflation expectations—especially during periods when government debt grows more quickly.
Corporate bonds typically offer higher yields but come with more credit risk and are fully taxable. Municipal bonds provide tax-exempt income and lower risk but generally offer lower yields.
While rising yields cause bond prices to fall, as they did in 2022, fixed-income investors can take advantage of elevated yields to pick up higher levels of income.
The twin factors that affect a bond's price are inflation and changing interest rates. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.
Risk Considerations: The primary risks associated with corporate bonds are credit risk, interest rate risk, and market risk. In addition, some corporate bonds can be called for redemption by the issuer and have their principal repaid prior to the maturity date.
If the new bonds have higher interest rates, the investors who buy them will make more money than you. On the other hand, your Treasury bonds will become more valuable if the newer interest rates are lower than yours. Orman explained that these rate changes affect bonds differently depending on their maturity.
Bond prices move inversely to changes in interest rates, so that if interest rates rise (or fall), bond prices fall (or rise). The longer a bond's duration, measured in years, the more sensitive its price to interest rate changes. Vanguard analysis based on Bloomberg data.