Interest rate sensitivity measures the fluctuations in the prices of fixed-income assets.
Fixed-income assets pay out a fixed rate of interest and are usually focused on the preservation of capital. Examples of fixed-income products include government or corporate bonds.
In the case of government or corporate bonds, money is loaned to the government or company in return for a fixed interest rate.
The government or company can then use the bond to raise more money through investments or spend on R&D and infrastructure.
Fixed-income products with greater interest rate sensitivity are subject to greater price fluctuations than those with lower interest rate sensitivity.
The sensitivity of a bond should be measured when selecting bonds as a rise in interest rates could cause the value of the bond to fall, meaning its value will be less when sold in a secondary market.
Moreover, an investor is missing out on a better investment opportunity if their capital is locked up in bonds when interest rates begin to rise.
Interest rate sensitivity explained
The sensitivity of interest rates generally rises with the duration of the bond or asset. The longer the investment window, the more likely it is that interest rates will rise or fall during that window.
A longer duration of bonds and other fixed-income assets is often indicative of greater interest rate sensitivity.
Duration is a useful gauge of potential interest rate sensitivity as it factors in bond characteristics like maturity and coupon payments.
What is duration?
Duration is a mathematical equation that includes all factors that affect the price of a bond of fixed-income assets.
The primary factors are the time to maturity, market rates and coupons – the annual interest payment received on a bond. Duration usually measures the total time it would take an investor to be repaid a bond via its total cash flows.
A bond’s duration is primarily influenced by:
- Time to maturity: longer maturity results in higher duration and higher interest rate risks. If two bonds are compared that yield 5% for £1,000, but have varying maturities, the fastest maturing bond repays its cost quicker than a bond with a slower maturity. The shorter maturity bond is less susceptible to interest rate changes by virtue of simple probability – the smaller the investment window, the lower the risk.
- Coupon rate: the bond’s coupon rate also affects duration, as a higher coupon rate means that the bond will be repaid faster. Higher coupon rates mean lower duration and lower risk.
As a rule of thumb, the greater the duration of the fixed-income asset, the more sensitive it’s likely to be. Long maturity bonds are amongst the more volatile and risky fixed-income assets, though they will often pay higher interest rates to compensate.
The same is true in the inverse. If interest rates fall then bonds with longer durations are more likely to rise in value compared to those with smaller durations.
Those who trade and invest in fixed-income assets watch interest rates closely for this reason.
For example, if interest rates increased by 1%, a 10-year bond with a duration of approximately 9 years could decrease in value by around 9%.
Conversely, if rates fell by 2% over the same period, the bond’s value could rise by around 18%.
By understanding interest-rate sensitivity, traders can take evasive action to immunise their fixed-income assets from temporary changes in interest rates.
Types of interest rate sensitivity
Duration measurements are not all built the same. There are four measurements used to gauge fixed-income interest sensitivity:
- Macaulay duration
- Modified duration
- Effective duration
- Key rate duration
The Macaulay duration, named after Canadian economist Frederick Macaulay, is the weighted average term to maturity of fixed-income cash flows.
This calculation requires the cash flows, time to maturity, bond price, coupon payment and required yield.
Modified duration is similar to the Macaulay duration but also incorporates yield to maturity, helping determine changes in duration resulting from changes to yield.
Effective duration helps calculate the changes in price if interest rates were to rise or fall by 1%, whereas the key rate determines duration at maturity as plotted on a yield curve.
What is interest rate sensitivity?
- Interest rate sensitivity is a measure or gauge of how vulnerable a fixed-income asset (such as a bond) is to interest rate changes.
- If interest rates rise, the value of a bond of fixed-income assets will typically decrease. The same is true in reverse.
- The longer the duration of the asset, the more sensitive it usually is to interest rate fluctuations.
- Duration is influenced by the coupon repayment as well as the maturity of the bond and other factors.
- Interest rate sensitivity is important for investors who are trying to immunise fixed-income portfolios from short-term changes in interest rates