Interest Rate Risk vs Credit Risk
Interest Rate Risk and Credit Risk are two Money, Banking & Finance concepts in AP Economics that students often mix up. Interest rate risk is the risk that rising market interest rates reduce the value of a bond or fixed-rate asset, since bond prices move inversely to rates. Credit risk is the risk that a borrower fails to repay a loan or bond, causing the lender to lose principal or interest. Here is how they compare side by side.
When market rates rise, existing bonds paying lower fixed coupons become less attractive, so their prices fall, and longer-maturity (higher-duration) bonds fall more. Banks face it because they fund long-term fixed-rate loans with short-term deposits whose cost rises with rates. It is separate from credit risk (default) and liquidity risk (can't sell/fund).
It is the core risk banks and bondholders bear: the chance an obligor defaults. Lenders price credit risk by charging higher interest to riskier borrowers, the default risk premium, and by checking credit ratings. Credit risk is distinct from interest-rate risk (rates moving) and liquidity risk (can't sell or fund quickly).
Interest Rate Risk vs Credit Risk: Two Ways a Bond Loses You Money
| Interest Rate Risk | Credit Risk | |
|---|---|---|
| What triggers the loss | Market interest rates rise | The issuer fails to pay |
| Loss if you hold to maturity | None, provided the issuer pays face value | Permanent, since the cash never arrives |
| Most exposed bonds | Long maturity and low coupon | Weak issuers with low credit ratings |
| Where it shows up | In the market price before maturity | In missed coupons or unpaid principal |
| A government bond in its own currency | Fully exposed | Close to none, since the issuer can create the currency |
| What compensates the investor | A term premium built into the yield curve | A default risk premium over the safe yield |
| How to reduce it | Shorten maturity or match assets to liabilities | Diversify across issuers and demand collateral |
A rate change hits the price without touching a single payment
Bond prices move inversely to yields, and the arithmetic is easiest on a bond that pays forever. Suppose an illustrative perpetual bond pays $50 a year, and the market yield on comparable bonds is 5 percent. Its price is $50 divided by 0.05, which is $1,000. Now let yields rise to 8 percent. The price becomes $50 divided by 0.08, which is $625. The holder has lost 37.5 percent of the market value even though the issuer has missed nothing and will keep paying $50 a year exactly as promised. That is the point students miss: the coupon is unchanged, and the loss is entirely about what else your money could now earn. Longer bonds fall further for the same rate move, because more of their payments are pushed into the discounted future, which is the same discounting shown at /calculate/present-value. This is why a bank that funds long fixed rate assets with short term deposits is exposed to rising rates in a way a bond default never captures. Hold to maturity and the paper loss unwinds, since the issuer still repays face value. Sell early, or be forced to sell, and it becomes real.
Credit risk is a probability problem, and the premium should cover it
Compare two bonds of the same maturity where an illustrative safe issuer yields 4 percent and a corporate issuer yields 7 percent. The 3 percentage point gap is the /glossary/default-risk-premium. Check whether it is enough with two assumptions, again illustrative: a 5 percent annual chance of default and a 40 percent recovery of face value if it happens. The loss given default is 60 percent, so the expected annual loss is 5 percent times 60 percent, which equals 3 percent. On these numbers the premium exactly covers expected losses and leaves nothing extra for bearing the uncertainty, which suggests an investor should demand more or look elsewhere. Notice what this calculation cannot do for a single bond. Expected loss is an average across many outcomes, and one bond either pays or it does not. That is why /glossary/diversification matters so much more for credit risk than for interest rate risk: holding fifty unrelated issuers makes the average close to the expectation, while holding fifty long bonds does nothing against a general rise in rates, because that shock hits all of them at once.
Frequently asked questions
What is the difference between interest rate risk and credit risk?
Interest rate risk is the chance that rising market yields cut the price of a bond you already own, while credit risk is the chance that the issuer stops paying. The first is a temporary price effect that reverses if you hold to maturity, and the second is a permanent loss of cash.
Do government bonds have interest rate risk?
Yes, and often more of it than corporate bonds, because government bonds tend to have long maturities and low coupons, which is exactly the combination that makes prices most sensitive to yields. Being nearly free of default risk protects the payments, not the market price.
Does diversification reduce interest rate risk?
Barely, because a rise in market rates pushes down the price of every fixed rate bond at once, so spreading money across issuers does not help. The tools that do work are shortening maturity, holding floating rate instruments, or matching the timing of your assets to the timing of your obligations.
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