How does interest rate risk impact investments?

Interest rate risk refers to the potential for the value of investments, particularly fixed-income securities like bonds, to decline as interest rates rise. When interest rates increase, newly issued bonds typically offer higher yields compared to existing bonds. As a result, existing bonds become less attractive, leading to a decrease in their market value. This decline in value reflects the inverse relationship between interest rates and bond prices; as rates go up, the prices of existing bonds generally fall.

The correct answer highlights this critical connection between interest rates and the value of securities, especially for those holding fixed-income investments. Investors must be aware that fluctuations in interest rates can significantly impact their portfolio, particularly those heavily weighted in bonds.

While short-term bonds may be less sensitive to changes in interest rates compared to long-term bonds, the risk still exists across the entire bond market. Additionally, rising interest rates would generally not lead to rising prices for bonds, as the two are inversely related. Furthermore, the assertion that interest rate risk does not affect equity funds does not account for the broader market dynamics influenced by interest rate changes, such as changes in consumer spending and borrowing costs, which can ultimately affect equity valuations.