Interest rate risk in fixed income investments refers to the potential for investment losses due to changes in interest rates. When interest rates rise, the value of existing bonds typically falls because newer bonds are issued with higher yields, making the older, lower-yielding bonds less attractive. Conversely, when interest rates fall, the value of existing bonds usually increases. Investors need to manage this risk to protect their portfolios.

Interest rate risk affects bond prices inversely. When interest rates rise, the prices of existing bonds fall. This is because new bonds are issued with higher yields, making older bonds with lower yields less attractive. Conversely, when interest rates fall, the prices of existing bonds rise as their higher yields become more attractive compared to newly issued bonds with lower yields.

Investors can use several strategies to manage interest rate risk, including diversifying their bond portfolios across different maturities, investing in bonds with shorter durations, using bond ladders, and incorporating floating-rate bonds. Additionally, investors can use interest rate derivatives such as options, futures, and swaps to hedge against interest rate movements.

Bond duration is a measure of the sensitivity of a bond’s price to changes in interest rates. It is expressed in years and represents the weighted average time until a bond’s cash flows are received. The higher the duration, the more sensitive the bond’s price is to changes in interest rates. Therefore, bonds with longer durations are more exposed to interest rate risk, while those with shorter durations are less affected by interest rate fluctuations.

A bond ladder is a strategy that involves purchasing bonds with different maturities. This approach helps mitigate interest rate risk by spreading out the investment across various time frames. As bonds in the ladder mature, the proceeds can be reinvested in new bonds at current interest rates. This strategy reduces the impact of interest rate changes on the entire portfolio and provides a steady stream of income over time.

Floating-rate bonds, also known as floaters, have variable interest rates that adjust periodically based on a benchmark interest rate. These bonds help manage interest rate risk because their coupon payments increase when interest rates rise, which helps maintain their value. As a result, floating-rate bonds are less sensitive to interest rate changes compared to fixed-rate bonds and can be a valuable addition to a diversified bond portfolio.