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Government bonds are considered to be nearly free of credit risk since the U. In fact, an economic crisis might help as market uncertainty drives bond investors to put their money into more quality bonds.

On the other hand, Treasuries and TIPS are highly sensitive to rising interest rates, or interest rate risk. When the market expects the Fed to raise interest rates , or when investors become concerned about inflation, the yields on Treasuries and TIPS will likely rise as their prices start falling. In this scenario, long-term bonds will perform much worse than their short-term counterparts.

However, these investments have a high sensitivity to interest rates.

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The MBS asset class can be hurt in two ways, first by a sharp increase in interest rates, which causes prices to fall. The second way involves a sharp decline in interest rates, which starts off a chain reaction beginning with homeowners who refinance their mortgages.

This leads to the return of principal, which then needs to be reinvested at lower rates and a lower yield than investors were anticipating since they earn no interest on the retired principal. MBS, therefore, tend to perform best in an environment of relatively stable interest rates. Not all municipal bonds are created alike. Municipal bonds on the higher-quality end of the spectrum have the probability of being very unlikely to default; therefore, interest rate risk is by far the largest factor in their performance.

As you move toward the higher-risk end of the spectrum, credit risk becomes the primary issue with municipal bonds, and interest rate risk has less of an impact. For instance, the financial crisis of , which brought with it actual defaults and fears of rising defaults for lower-quality bonds of all types, led to an extremely poor performance for lower-rated, high-yielding munis, with many bond mutual funds losing over 20 percent of their value. The takeaway?

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Corporate bonds present a hybrid of interest rate and credit risk. At the same time, corporations are seen as less financially stable than the U. Higher-rated, lower-yielding corporate bonds tend to be more rate-sensitive because their yields are closer to Treasury yields and also because investors see them as being less likely to default.

explain how a bond’s maturity, coupon, and yield level affect its interest rate risk;

Our research and investment strategies seek to help investors capitalize on the power of preference. A guide for your journey.

Consider Premium Bonds To Counter Interest Rate Risk

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The problems you face keep us up at night, too. Estate planning. Auto insurance. Sizing up risks So you think bonds are totally safe and predictable? Many people believe they can't lose money in bonds.

Interest Rate Risk

Although the interest payments you'll get from owning a bond are "fixed," your return is anything but. Here are the major risks that can affect your bond's return: "Inflation risk:" Since bond interest payments are fixed, their value can be eroded by inflation.

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The longer the term of the bond, the higher the inflation risk. On the other hand, bonds are a classic deflation hedge; deflation increases the value of the dollars that bond investors get paid. When rates rise, bond prices fall because new bonds are issued paying higher coupons, making the older, lower-yielding bonds less attractive. Conversely, bond prices rise when interest rates fall because the higher payouts on the old bonds look more attractive relative to the lower rates offered on newer ones.

The longer the term of the bond, the greater the price fluctuation, or volatility, that results from any change in interest rates. As you might surmise, there is a close connection between inflation risk and interest rate risk since interest rates tend to rise along with inflation. Interest rate shifts are also a concern for mortgage-backed bondholders, but for a different reason: If interest rates fall, home owners may decide to prepay their existing mortgages and take out new ones at the lower rates.

That doesn't mean you'll lose your principal, if you happen to hold such a bond. But it does mean you get your principal back much sooner than expected, forcing you to reinvest it at the newly lower rates.

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  5. For that reason, the prices of mortgage-backed securities don't get as big a boost from falling rates as other kinds of bonds. Note, though, that price fluctuations only matter if you intend to sell a bond before maturity, or you invest in a bond fund whose manager trades regularly more below. If you hold a bond to its maturity, you will be repaid the bond's full face value. But what if interest rates fall and the issuer of your bond wants to lower its interest costs?

    This brings us to the next type of risk Typically, this happens if interest rates fall and the issuer sees it can lower its costs by selling new bonds with lower yields. If you happen to own one of the called bonds, not only do you get less than the market price of the bond, but you also have to find a place to reinvest the money.