Rate Level Risk

Bond trading is like dating. The attractiveness of what you have changes based on your options. If you’re a busker in the subway, you’ll put up with more nonsense from a significant other than you will have once you become a millionaire-globe-hopping rock star.

Similarly, the attractiveness of a particular bond depends on what else is out there. To put it another way, the value of a bond changes as the overall interest rate environment changes.

A return of 3% on a bond looks fine when the average rate for that maturity sits at 2%. However, in an environment when you can get 5% for the same amount of risk, those 3% bonds start to look bad. You might start ignoring their texts and removing their pictures from your Facebook page.

The rate-level risk describes this situation. It refers to the fact that bond values fluctuate based on the overall interest rate environment. You buy the 3% bond at at a time when it looks like a good investment, based on the return you can get elsewhere for similar risk. If that environment changes, however (if overall rates rise), suddenly that bond doesn't seem as valuable.

Fundamentally, rate-level risk refers to the risk to bond prices related to changes in the overall rate environment. So the risks don't have anything to do with that particular bond. The risks completely stem from the chances that something will change in the general market situation.