Interest Rate Risk and Credit Risk Are Not the Same Risk

Two risks behind the word “risk”

The distinction between interest rate risk and credit risk starts with two questions. What would someone pay for the investment today? How much of the promised cash will the borrower actually pay? The first answer can change because comparable investments now offer higher rates. The second can change because the borrower’s finances have weakened.

Interest rate risk is the possibility that a change in market rates affects the value of a debt investment. Credit risk is the possibility that the borrower pays late, repays only part of what it owes or fails to repay. Both can affect the same position. A bond’s price can fall because market yields rose, because investors doubt the issuer will pay, or because both happened together.

Is a loan claim safer than a bond?

The answer depends on the borrower and how long the investor expects to hold the debt. A short fixed-rate loan held to maturity can have less exposure to rate-driven price changes than a long traded bond, while carrying more credit risk than a bond from a financially strong issuer. When comparing peer-to-peer lending with bonds, check who owes the money, when it is due and whether an early sale is likely.

Why bond prices fall when rates rise

What happens to bond prices when interest rates rise?

Prices of existing fixed-rate bonds generally fall when yields on comparable bonds rise, all else equal. The existing bond still pays its original coupon. If a new bond of similar credit quality and maturity offers a higher yield, a buyer will generally pay less for the old one. That lower price raises the yield the buyer can earn from its remaining payments.

The distinction between a bond’s coupon and its market price matters when an investor needs to sell. A sale locks in the price available that day. An investor who holds the bond to maturity can still receive the scheduled coupon and principal payments if the issuer pays as agreed, even if the market price fell during the holding period.

What is duration in bonds?

Duration describes how sensitive a bond’s price is to a change in yield. A bond with higher duration generally moves more in price for the same change in yield. Long fixed-rate bonds tend to have higher duration than comparable short bonds because more of their value comes from payments further in the future. The size and timing of coupons matter too, so bonds with the same maturity can have different durations.

Consider two bonds from the same issuer. One repays principal soon. The other leaves most of the investor’s money tied to a fixed coupon for years. When yields rise, the first bond’s principal will soon be available to reinvest at the new rates. The second bond’s buyer would be accepting the old coupon for longer, so its price generally needs to move further. In discussions of loan duration and yield, duration often means the loan term. In bond analysis it refers to price sensitivity.

What a short fixed-rate loan owes at maturity

Does a short-term loan have interest rate risk?

Yes, though a short fixed-rate loan held to maturity has limited direct exposure through its scheduled payments. If market rates rise halfway through the term, the borrower still owes the interest agreed in the contract. If rates fall, the scheduled amount also stays the same. The investor receives those payments only if the borrower makes them.

Holding the claim to maturity removes the need to accept a resale price. Its economic value can still change while the investor holds it. For example, comparable new claims may begin offering more interest, while the investor’s money remains committed at the old rate. That difference can affect what a buyer will pay if the investor decides to sell before maturity.

Fixed-rate loan market risk: early sale and reinvestment

Early sale. A buyer can compare the remaining payments on an existing claim with the terms available on similar new claims. If the new offers pay more, the buyer may ask for a discount. On Maclear’s Secondary Market, eligible claims can be listed at par or at a discount of up to 50%. The platform does not allow listings above par, and a sale requires a buyer willing to accept the price.

Illustrative example only. Take a fixed-rate claim with €1,000 in outstanding principal and six months left. Assume one remaining payment of €1,040, including €40 in interest, and use €1,000 as the illustrative par price. At that price, a buyer would earn 4% over six months if the borrower paid in full. Now suppose comparable new offers provide a 5% return over the same period. The example excludes fees.

To earn 5% on the same €1,040 payment, the buyer would pay €1,040 ÷ 1.05 ≈ €990.48. That is €9.52 below par, a discount of about 0.95%. The figure illustrates how a higher required return can affect the price. Actual buyers may ask for a different discount or decline the listing. An investor who holds the claim and receives full repayment collects the contractual amount without selling at that discount.

Reinvestment after repayment. Once principal comes back, the investor can lend it again on the terms available at that point. Lower rates can reduce the interest the next claim earns, while higher rates can increase it. The same question comes up sooner when a borrower repays early, because the money becomes available before the expected maturity date.

Credit risk explained for lenders

What risk does a lender actually take on a fixed-rate loan?

The lender chiefly takes the risk that the borrower will fall short of the agreed payments. A business can lose a customer, collect invoices later than planned or face costs that leave too little cash for its next instalment. The rate determines the interest due. The business’s cash position determines whether it can pay on time.

Market rates can affect that cash position indirectly. If the borrower needs to refinance other debt at a higher rate, the extra expense can leave less money for existing obligations. A missed payment on the original claim is then a credit outcome, even if higher market rates contributed to it. The contractual rate on that claim has stayed the same.

A short fixed-rate loan held to maturity does not avoid risk - it trades interest rate risk for credit risk: the outcome depends on whether that specific borrower repays, not on where market rates move.

Frequently asked questions

What is the difference between interest rate risk and credit risk?

Interest rate risk concerns how a change in market rates affects an investment’s value. Credit risk concerns whether the borrower makes the promised payments. The resale price of a long traded bond can be particularly sensitive to rates, while the outcome of a short fixed-rate claim held to maturity depends chiefly on repayment.

Does a short-term loan have interest rate risk?

Yes, but the scheduled payments on a short fixed-rate loan stay the same when market rates change. If the investor sells early, those rates can affect the price a buyer offers. After repayment, the terms available on new loans determine what the investor can earn by lending the money again.

Why does a bond’s price fall when interest rates rise?

An existing fixed-rate bond generally falls in price when comparable new bonds offer higher yields. Paying less for the existing bond raises the yield a buyer can earn from its unchanged payments. The price effect is usually larger for a bond with higher duration, all else equal.

What is duration in simple terms?

Duration describes how sensitive a bond’s price is to changes in market yields. The higher the duration, the larger the price movement for a given change in yield, all else equal. Longer fixed-rate bonds generally have higher duration than comparable short bonds, although coupon size and payment timing also matter.

Is a loan claim safer than a bond?

It depends on who owes the payments and whether the investor plans to sell before maturity. A short fixed-rate loan can have less exposure to rate-driven price changes while carrying more credit risk than a high-grade bond. A bond can also carry significant credit risk if its issuer’s finances are weak.

The content of this article is provided for informational and educational purposes only. It does not constitute investment, financial, tax, or legal advice. Peer-to-peer (P2P) lending and crowdlending investments carry a risk of partial or total loss of capital. Past performance does not predict future results. Liquidity on a secondary market is not guaranteed. Readers are encouraged to conduct their own research and consult qualified advisors before making any financial decisions. The availability of products and services may be restricted in certain jurisdictions.