Interest Rate Risk

Posted October 28, 2025, By Cole Ferrier

Key Takeaways:

• Interest Rate Risk is the danger that a rise in interest rates will cause the market value of your existing, lower-yielding bonds to fall.

• While rising rates cause bond prices to drop, it also means the future expected return of your bond holdings has increased, as new money can be invested at higher yields.

• The impact of a rate change depends on your time horizon relative to your portfolio's duration. If your horizon is longer than your duration, a rate increase could ultimately end up being a net positive.

• You can manage this risk by holding shorter-duration bonds, building a ladder of individual bonds that you hold to maturity, and diversifying across different types of fixed-income assets.

In our last article, we confronted Market Risk—the inherent volatility of the stock market. For most investors, that’s where the conversation about risk ends. They see stocks as the risky "engine" and bonds as the safe, predictable "brakes" of their portfolio. But as millions of retirees discovered in 2022, the brakes can fail in unexpected ways. This brings us to a subtle but powerful threat: Interest Rate Risk.

Interest rate risk is the often-overlooked danger that your "safe" bond portfolio can lose significant value. It’s a counterintuitive concept for many, who believe that bonds are all about preserving capital. But when interest rates in the broader economy rise, the fixed, lower-rate bonds you already own suddenly become less attractive, and their market price falls to compensate.

From an engineering perspective, this is a lesson in understanding system dynamics. Every component has its own operational tolerances and failure points. Assuming your bond portfolio is a risk-free anchor is a design flaw. It ignores the powerful and inverse relationship between interest rates and bond prices—a fundamental force that can destabilize the very part of your portfolio meant to provide stability.

By the Numbers

• -13.01%: The total return of the Bloomberg U.S. Aggregate Bond Index in 2022, the worst single year in the index's history, driven by the Federal Reserve's aggressive interest rate hikes to combat inflation. (Source: Vanguard, "Bond market volatility: What to know," 2023)

• 4.25 percentage points: The amount the Federal Reserve raised the federal funds rate in 2022 alone, one of the fastest tightening cycles in modern history. (Source: Federal Reserve Board, "Open Market Operations," 2023)

• 6.2 years: The approximate duration of the Bloomberg U.S. Aggregate Bond Index. This means that for every 1% increase in interest rates, the index's value is expected to fall by about 6.2%. (Source: iShares by BlackRock, data for AGG ETF, 2024)

From the Case Files

Meet Arthur, a 68-year-old retiree with a $2 million portfolio. Being risk-averse, he and his previous advisor had structured his portfolio "conservatively" with a 60% allocation to a well-regarded total bond market mutual fund and 40% to stocks. He felt secure. At the start of 2022, his $1.2 million bond allocation seemed like a fortress. But as the Federal Reserve raised rates throughout the year, he was shocked to see the value of his "safe" bond fund plummet by over $150,000. He hadn't lost money because of risky stocks; he'd lost it because he didn't understand that his bond fund was fully exposed to interest rate risk.

Understanding the Risk: The Bond Market Seesaw

The relationship between interest rates and bond prices is like a seesaw. When one goes up, the other goes down.

Imagine you own a 10-year government bond that pays a 2% interest coupon. A year later, due to a changing economy, the government issues new 10-year bonds that pay 4%. If you wanted to sell your 2% bond, who would buy it when they could get a new one that pays twice as much? The only way to sell your bond is to drop its price to a level where its effective yield matches the new 4% rate. The market value of your "safe" asset has fallen.

The key metric for measuring this sensitivity is duration. In simple terms, a bond's duration is a measure of how many years it will take for an investor to be repaid the bond's price by its total cash flows. More practically, it's a direct measure of risk: for every 1% change in interest rates, a bond's price will move in the opposite direction by a percentage roughly equal to its duration.

The Silver Lining: Higher Expected Returns

However, this is not the whole story. While the drop in your bond fund's value is painful, it's crucial to understand the upside: the future expected return of your bond holdings has now gone up. Your existing bonds are now priced to yield more, and any new money you invest—or any principal from maturing bonds—can be reinvested at the new, higher rates.

This creates a critical relationship between a bond portfolio's duration and your personal time horizon (when you need the money).

• Time Horizon = Duration: If you need your money in seven years and your bond fund has a seven-year duration, the impact of a rate rise is largely neutral in the long run. The initial loss in principal will be offset by the higher income you receive from reinvesting the bond's cash flows at the new, higher rates over those seven years.

• Time Horizon > Duration: If your bond fund has a five-year duration but you don't need the money for ten years, a rate increase could be a net positive for you. The initial price drop is a short-term paper loss that is eventually more than offset by the benefit of reinvesting at higher rates for a longer period.

• Time Horizon < Duration: This is the danger zone, and the situation Arthur found himself in. If you have a ten-year duration bond portfolio but need the money in two years, you are forced to sell your bonds at a significant loss before the higher reinvestment income has time to make up for it.

The Impact on Your Plan: When Diversification Fails

Interest rate risk can be particularly dangerous because it can strike at the heart of your plan's defenses.

• Interaction with Market Risk and Inflation Risk: The year 2022 was a perfect storm because rising interest rates were the Federal Reserve's tool to fight high Inflation Risk. This caused both stock prices (Market Risk) and bond prices (Interest Rate Risk) to fall simultaneously. The traditional diversification benefit—where bonds zig when stocks zag—failed completely, leaving retirees with nowhere to hide.

• Reinvestment Risk: This is the other side of the interest rate seesaw. If interest rates fall, your existing bonds may rise in value, but when they mature or when you have new cash to invest, you are forced to reinvest at lower rates. This is a significant threat to the long-term income-generating potential of a bond portfolio.

• Interaction with Longevity Risk: Over a multi-decade retirement, you are guaranteed to experience multiple interest rate cycles. A period of rising rates can hurt your principal, while a long period of low rates can starve your portfolio of the income it needs to last, forcing you to take on more equity risk than you might be comfortable with.

Solutions & Your Risk Mitigation Toolkit

You cannot eliminate interest rate risk, but you can manage its impact on your portfolio and ensure your "safe" money stays stable when you need it most.

• Tool #1: Manage Duration. The simplest way to reduce interest rate risk is to shorten the average duration of your bond holdings. Avoid the temptation to reach for the slightly higher yields offered by long-term bonds. By keeping your bond portfolio in the short-to-intermediate term (e.g., an average duration of 3-7 years), you significantly reduce its volatility and sensitivity to rate changes.

• Tool #2: Build a Bond Ladder. Instead of owning a bond fund, you can purchase a series of individual, high-quality bonds that mature in sequential years (e.g., one bond maturing every year for the next 10 years). You can then use the principal from the maturing bond to cover that year's living expenses. By having individual bonds, this allows someone to use mental accounting to effectively ignore the interim fluctuations in the market price of their bonds. This is a powerful way to leverage a cognitive bias to be more comfortable with interest rate risk.

• Tool #3: Diversify Your Fixed Income. Just as with stocks, diversification helps. A mix of U.S. Treasuries, high-quality corporate bonds, Treasury Inflation-Protected Securities (TIPS), and even international bonds can provide different risk characteristics and help smooth your returns.

• Tool #4: Remember the Role of Bonds. The primary job of high-quality bonds in a retirement portfolio is not to generate high returns. It is to act as a stable "shock absorber" against the volatility of your stock portfolio. Accepting a lower yield in exchange for lower duration and higher credit quality is often the right trade-off to ensure your bonds can do their job when you need them most.

A Framework for Managing Interest Rate Risk

Strategically, interest rate risk is the danger that the "safe" portion of your portfolio will lose value when interest rates rise, undermining its role as a stabilizer. A plan is most vulnerable when its bond holdings are overly sensitive to rate changes—a characteristic measured by duration. This can cause the very asset class meant to provide stability to become a source of significant loss, as many retirees discovered in 2022.

A resilient plan addresses this by deliberately constructing the bond portfolio to reduce its volatility. Key strategies include shortening the overall duration of your bond holdings, diversifying across different types of fixed income, and for critical near-term income, building a ladder of individual bonds held to maturity to effectively eliminate price fluctuations for that capital.

Conclusion: The Great Balancing Act

The fundamental trade-off in the bond market is between yield and safety. Chasing a higher yield almost always means taking on more risk. The "great balancing act" for a retiree is to build a fixed-income portfolio that provides a reliable shock absorber for the equity side of the house without introducing too much volatility of its own.

Understanding duration isn't just about fearing loss; it's about aligning your strategy with your timeline. By managing duration to match your goals, you can navigate the seesaw of interest rates and ensure your "safe" money is not only a source of stability but a tool that can capitalize on the opportunities that changing rates provide.

Create Your Financial Compass with Us

Did the 2022 bond market surprise you? Understanding the nuances of fixed-income investing is critical to building a truly resilient retirement portfolio. We can help you analyze your current bond holdings and design a strategy that aligns with your need for stability. Contact us today.

Resources:

• FINRA - Investing in Bonds: An investor education resource covering the basics of bond investing, including the risks. (www.finra.org/investors/learn-to-invest/types-investments/bonds)

• Treasury Direct: The official U.S. government website for buying Treasury bills, notes, and bonds directly from the government. (www.treasurydirect.gov)

• Morningstar - Bond Basics: A collection of articles and videos explaining bond terminology and strategies. (www.morningstar.com/bonds)