Duration and Interest Rate Risk: A Rule of Thumb

Interest rate risk is a key factor to consider when managing an investment portfolio, especially in a volatile economic environment. Changes in interest rates can have an impact on the value of various asset classes. This risk is particularly relevant for fixed income investments like bonds, where rising interest rates generally lead to falling bond prices and vice versa. 

How Does Duration Relate to Interest Rate Risk? 

Duration is a key concept that helps investors measure a bond’s sensitivity to changes in interest rates. Expressed in years, duration estimates how much a bond’s price is expected to change in response to changes in interest rates. As a rule of thumb, for every 1% change in interest rates, the price of a bond will move by approximately 1% in the opposite direction for each year of duration. For example, if a bond has a duration of five years, its price should decrease by approximately 5% if interest rates rise by 1%. Conversely, a bond’s price should rise by the same percentage if rates fall by 1%. 

Longer-duration bonds carry greater interest rate risk because they are more sensitive to changes in interest rates. In contrast, shorter-duration bonds are less affected by interest rate fluctuations, offering a lower level of risk for investors in rising rate environments. 

Why It Matters to Your Portfolio 

Managing interest rate risk is crucial for protecting your portfolio’s value and achieving your investment goals. By understanding duration, investors can make more informed decisions about the composition of their asset allocation, especially fixed-income, helping balance risk and return in light of current and anticipated interest rate trends.

Our Approach to Risk 

We actively manage our fixed income exposure and do not advise buy-and-hold fixed income solutions. It’s crucial for investors to understand the potential impact on their portfolio in taking a passive approach to risk. Investors might say they can endure interest rate volatility until maturity, but are they truly prepared for it?  

Contact CapRidge Advisors today to learn about our total portfolio approach to risk management and how we can develop a strategy tailored to your financial objectives. 

For further reading on interest rate risk and duration, visit Investopedia’s guide.