Interest rate risk is a mother!
Investors that don’t like risks hate it. And investors that’re willing to deal with risks hate it! Although, technically, any investor doesn’t like risks…
But to become better investors together, it’s great to understand what makes interest rates risky.
Real Interest Rate
The first component to understand and grasp interest rate risk is real interest rate. To define it simply, real interest rate is the interest an investor receives after taking inflation out of consideration. In an equation, real interest rate equals nominal interest rate minus the inflation rate. Lenders want to know the real interest rate because they want to know how much they’ll actually receive on the deal. For borrowers, real interest rate is taken into account to find out what the true cost of funds are.
It’s also important to know institutions use nominal rates to back investments or loans. Nominal interest rates change to compensate for inflation while the real interest rate doesn’t. Think of nominal interest rates like make-up, and real interest rates like bare skin. That’s how institutions get you, they try to attract you with higher rates, but as a savvy investor, you’ll see right through their games.
Now let’s talk about the component which factors into interest rate risk.
The ultimate economy destroyer is inflation. Do you want to not be able to pay for goods? Ask for inflation. Want to make sure people lose jobs? Make sure inflation is around. D you want the value of your hard earned money to go down? Don’t forget about inflation!
The relationship between inflation and interest rate risk is inverse. Their relationship goes in opposite directions. When one of them goes up, the other goes down. Let me give you a quick example.
When interest rates begin to rise, loans and investments begin to get more expensive. This causes people to stay away from loans and investments resulting in less money in the economy causing deflation. If interest rates are low, then borrowers are more willing to take the risk which means more money in the economy causing inflation. It’s easier to grasp the concepts if you go from either a lender’s perspective, or borrower’s perspective.
But inflation is just one of the components to worry about.
Liquidity Risk Premium
Think of liquidity risk premium as compensation for investing funds in something that’s difficult to sell. They’re usually for assets that’re long-term and illiquid. The premium can range depending on the amount of time the investment is locked up, and how illiquid the asset is. Short-term investments don’t offer these for lenders because short-term investments are easier to convert to cash on the secondary market.
Examples of illiquid investments are real estate, companies, loans, certificates of deposits, and more. For them to be iliiquid, they just have to be hard to sell. And when an asset is on the market for awhile, that can cause its value to go down which is another risk for illiquid assets.
If you have the funds to secure a long-term investment, then look at liquidity premium as an incentive.
It’s time to move on to another component of interest rate risk.
Credit risk is the risk that the bond or loan won’t be repaid on time, or at all.
If you’re an investor, this just sucks. Imagine giving a huge amount and not getting paid for any of it. That is credit risk.
But how can you find the best recipients for investing with? Use credit rating agencies. These agencies will help you determine which issuers are best fit to repay their debts, and gives them grades to determine who is worth giving to, and who’s not. If you’re a quality issuer, then your described as “investment grade”, but if you are below quality, then you’re known as “less than investment grade.” Let’s look at an example to see how credit risk plays a role.
If you’re a real estate investor and are looking to get a mortgage, banks will look at the 5 C’s. Credit history, capacity to repay, loan’s conditions, capital, and collateral. If it looks like you’re unable to pay back debt, then you wouldn’t fit the description of “capacity to repay.” This is how credit risk relates to investing, specifically real estate.
On the other hand, if an investor is looking at getting a bond, then they can use a credit rating agency to see who is the best issuer. One of the best issuers is the government. If they don’t have the money themselves, they can just print money or levy taxes as an authority. Both situations work. But it’s best to evaluate using credit rating agencies just to be safe.
Now how does credit risk affect interest rate risk?
Think of it like this. If you want to lend money to somebody, but their financials and history indicate they’re a high risk of default, would you want to compensate your risk with a low interest rate? Or a high interest rate? If you said high interest rate, you’re right.
It all comes down to how much risk there is. If there’s a lot, then the interest rate should be higher. If there’s a little, then the interest rate should be lower. The relationship between interest rates and risk go up and down together, and its something to always keep track of as an investor.