Sources of interest rate risk
Interest rate risk in fixed income has several components. Level risk: parallel shifts in the yield curve (all maturities move by the same amount) — the dominant source. Slope risk: the yield curve steepens or flattens — a 2-year/10-year spread narrowing can hurt positions that relied on the curve shape. Curvature (butterfly) risk: the middle of the yield curve moves differently from the short and long ends. For most portfolios, level risk dominates, but professional fixed income managers decompose all three. Key Point: Risk Free Rate (RFR) benchmarks (SOFR in the US, SONIA in the UK) replaced LIBOR in 2021 — all floating rate instruments and many derivatives now reference these overnight rates.
Liability-driven investing (LDI)
The most sophisticated application of interest rate risk hedging is Liability-Driven Investing (LDI), used by defined benefit pension funds to match the interest rate sensitivity of their liability book (the present value of future pension payments, which rises when rates fall) with their asset portfolio. In a perfect LDI implementation, if rates fall and liabilities increase by £100m, the asset portfolio rises by £100m through long-duration bonds and interest rate swap receivers (receive fixed = profit when rates fall). The 2022 UK gilt crisis exposed a critical vulnerability: pension funds using leveraged LDI (using repo and derivatives to amplify their duration exposure) faced catastrophic margin calls when gilts fell sharply, forcing emergency Bank of England intervention. The crisis revealed that leverage in LDI strategies had been underestimated as a systemic risk.
What this means for you
Interest rate risk is the reason "safe" government bond funds lost 20–30% in 2022. Understanding duration and DV01 is essential for anyone managing a fixed income portfolio, whether institutional or personal. For individuals, the practical tool is simple: match the duration of your bond holdings to your investment horizon. If you need the money in 3 years, hold bonds with 3-year or shorter duration. If you are investing for 20+ years, duration risk is a short-term mark-to-market issue, not a permanent loss — as long as you hold to maturity, rising rates actually improve your long-run return by allowing reinvestment of coupons at higher rates.