The vast majority of products available for investment that yield interest offer fixed rate returns. A fixed rate return means that if you purchase an investment that offers a 1 percent annual interest rate, then you’re going to earn 1 percent annually — no more, no less.
When you earn 1 percent interest on an investment, it doesn’t matter whether interest rates go up or down during that time, nor does it matter how high inflation rates go; you still only earn 1 percent. This risk of losing value on assets because the interest rates you earn have the potential to lag behind market interest rates or inflation rates is called interest rate risk.
The interest rate can quite easily outpace the rate inherent in a number of other investments. If you purchase a bond that pays 1 percent per year in cash flows (in other words, every year the bond earns you another 1 percent of the purchase price in coupon payments), but then the market interest rate increases to 2 percent, the value of your future cash flows decreases by 50 percent relative to the market rate.
So, if you ever try to sell the bond or any part of it, it won’t be worth nearly as much, and even if you continue to hold the bond, your future cash flows won’t be keeping up with market returns.
The risk that inflation will outpace your assets is often categorized as a special type of interest rate risk called inflationary risk. This form of risk is really quite simple to understand. Inflation means that the overall price level within a nation increases.
Remember how bread, eggs, and fuel used to be much cheaper than they are today? That’s because inflation reduces the amount of goods you can purchase with a single unit of currency. In other words, if inflation increases by 1 percent in a year, then $1 will purchase 1 percent less next year than it does this year.
So, if you have your money in an investment that’s earning 0.5 percent interest each year, you’re losing 0.5 percent of the purchasing power of the currency, reducing the real value of your investment even if the nominal value is increasing. This is usually only a problem with investments that are considered “risk free,” such as treasury bills, certificates of deposit, savings accounts, and some low-yield bonds.