Introduction to Interest Rate Risk in Stock Investments - dummies

Introduction to Interest Rate Risk in Stock Investments

By Paul Mladjenovic

You can lose money in an apparently sound stock investment because of something that sounds as harmless as “interest rates have changed.” Interest rate risk may sound like an odd type of risk, but in fact, it’s a common consideration for investors. Be aware that interest rates change on a regular basis, causing some challenging moments.

Banks set interest rates, and the primary institution to watch closely is the Federal Reserve (the Fed), which is, in effect, the country’s central bank. The Fed raises or lowers its interest rates, actions that, in turn, cause banks to raise or lower their interest rates accordingly. Interest rate changes affect consumers, businesses, and, of course, investors.

Here’s a generic introduction to the way fluctuating interest rate risk can affect investors in general: Suppose that you buy a long-term, high-quality corporate bond and get a yield of 6 percent. Your money is safe, and your return is locked in at 6 percent. Whew! That’s 6 percent. Not bad, huh?

But what happens if, after you commit your money, interest rates increase to 8 percent? You lose the opportunity to get that extra 2-percent interest. The only way to get out of your 6-percent bond is to sell it at current market values and use the money to reinvest at the higher rate.

The only problem with this scenario is that the 6-percent bond is likely to drop in value because interest rates rose. Say that the investor is Bob and the bond yielding 6 percent is a corporate bond issued by Lucin-Muny. According to the bond agreement, LM must pay 6 percent (called the face rate or nominal rate) during the life of the bond and then, upon maturity, pay the principal.

If Bob buys $10,000 of LM bonds on the day they’re issued, he gets $600 (of interest) every year for as long as he holds the bonds. If he holds on until maturity, he gets back his $10,000 (the principal). So far so good, right? The plot thickens, however.

Say that he decides to sell the bonds long before maturity and that, at the time of the sale, interest rates in the market have risen to 8 percent. Now what? The reality is that no one is going to want his 6-percent bonds if the market is offering bonds at 8 percent.

What’s Bob to do? He can’t change the face rate of 6 percent, and he can’t change the fact that only $600 is paid each year for the life of the bonds. What has to change so that current investors get the equivalent yield of 8 percent? The bond’s value, instead, has to go down.

In this example, the bonds’ market value needs to drop to $7,500 so that investors buying the bonds get an equivalent yield of 8 percent. New investors still get $600 annually. However, $600 is equal to 8 percent of $7,500. Therefore, even though investors get the face rate of 6 percent, they get a yield of 8 percent because the actual investment amount is $7,500.

In this example, little, if any, financial risk is present, but you see how interest rate risk presents itself. Bob finds out that you can have a good company with a good bond yet still lose $2,500 because of the change in the interest rate. Of course, if Bob doesn’t sell, he doesn’t realize that loss.