Interest rate risk

Interest rate risk (IRR) refers to the potential for a change in interest rates to reduce the value of an investment or asset. For example: When interest rates increase, bond prices typically decrease, and conversely, when interest rates decline, bond prices tend to rise. This occurs because the market value of existing bonds adjusts to align with the attractiveness of newly issued bonds offering higher or lower rates.

When you think of risky investments, equity stocks and equity funds may be the first options you recall. While these investments are undoubtedly risky, all investments carry some kind of risk — even relatively safer assets like debt instruments. In fact, they are particularly vulnerable to interest rate risk.

In this article, we explore the meaning of interest rate risk, understand how it works in the context of mutual funds and how you can mitigate this risk in your portfolio.

What is interest rate risk?

Interest rate risk refers to the chance that an asset's value may fall due to unforeseen changes in interest rates. This type of risk is primarily linked to fixed-income investments like bonds, as opposed to stocks. A bond’s price is heavily influenced by interest rate movements, making this a key factor in its valuation.

Bond and debt instrument prices are inversely correlated with interest rates. So, if the interest rates increase, bond prices will fall. Conversely, if the interest rates decline, bonds will see a rise in value.

Example of Interest rate risk

Existing investors with older bonds lose out on the higher interest payouts from the newly issued bonds. This creates an opportunity cost and makes older bonds with lower interest rates less attractive to investors. Consequently, the market values of such bonds decline.

For instance, say you hold government bonds worth Rs. 1,00,000 from an old tranche that pays interest at 6% per annum. The value of these investments would rise to Rs. 1,06,000 in one year (i.e. Rs. 1,00,000 + 6%).

Now, let us assume that due to rising interest rates, the government offers interest at the rate of 7.5% per annum on newly issued bonds. Rs. 1,00,000 worth of these new bonds would rise to Rs. 1,07,500 in one year. This means you lose out on Rs. 1,500 during the year because of the lower interest rate on your bond holdings.

Also read: Difference between assets and liabilities

Types of interest rate risk

Interest rate risk can manifest in different ways. Here are two common ways in which this risk affects investments. 

1. Price risk
   This is the possibility of the price (or value) of a debt instrument reducing because of changing interest rates. It is the most common way in which interest rate risk affects fixed-income securities.
2. Reinvestment risk
   Reinvestment risk is a component of interest rate risk that occurs when you are unable to reinvest your money at the same rate of return as your original investment. For instance, say you hold a bond that pays a high rate of interest, and it attains maturity. At this point, if the prevailing rates have decreased, you might have to reinvest the proceeds at a lower interest rate.

How does interest rate risk work?

Interest rate risk arises when changes in interest rates impact the value of financial assets, particularly fixed-income securities like bonds. When interest rates rise, the price of existing bonds typically falls, as newly issued bonds offer higher returns, making the older, lower-yielding bonds less attractive. Conversely, when interest rates decline, the value of existing bonds rises, as their yields become more competitive compared to newer bonds issued at lower rates.

The extent of this risk depends on the bond's maturity and coupon rate. Longer-term bonds are more susceptible to interest rate fluctuations because investors are locked into a fixed rate for an extended period, making the bond's value more sensitive to interest rate changes. Additionally, bonds with lower coupon rates tend to be more vulnerable to interest rate risk, as their lower interest payments are less appealing when rates rise.

In a broader context, interest rate risk can affect a wide range of investments, from corporate bonds and government securities to real estate and equity markets. Investors need to consider this risk when constructing portfolios, especially in a rising rate environment, as it can significantly influence returns. Diversifying investments can help mitigate the impact of interest rate fluctuations.

Ways to manage interest rate risk in mutual funds

Understanding what interest rate risk is and how it affects mutual funds is essential for becoming a savvy investor. However, it’s equally important to know how to reduce this risk in your mutual fund portfolio. The following strategies can help you manage and minimise interest rate risk effectively.

Diversification

• Diversification: Diversifying your portfolio is one of the most effective ways to minimise interest rate risk as well as other kinds of risk. Choose funds that hold bonds with varying maturities. Alternatively, you could also diversify your portfolio using hybrid mutual funds that invest in both debt and equity markets.

Choosing safer investments

• Choosing safer investments: Another way to manage this risk is to choose safer investments that benefit from interest rate changes. For instance, you could consider floating-rate funds that invest in floating-rate debt instruments. In these securities, the coupon rates are periodically adjusted based on the prevailing interest rates in the market. This reduces the interest rate risk because such instruments do not lose value when interest rates change. Alternatively, short-term debt instruments that are less sensitive to interest rate risk may also be suitable. This is because they may attain maturity even before the next interest rate change occurs. So, you could consider choosing debt mutual funds with short-term investment horizons to avoid being affected by this factor.

Interest rate hedging

• Interest rate hedging: Interest rate hedging is the process of using derivative instruments like options or interest rate swaps to offset the loss in value in your mutual fund portfolio due to interest rate risk. It involves taking an opposite position in the market so you can benefit from an increase in the interest rates.

Does interest rate risk matter to mutual fund investors?

Now that you know how interest rate risk works, you may be wondering if this risk matters to mutual fund investors. The short answer is yes. More specifically, debt-oriented mutual funds that mainly hold debt instruments and fixed-income securities are particularly affected by interest rate changes.

This is because the values of the securities in the fund’s asset mix are impacted by rising and falling interest rates. If you are planning to invest in debt funds, you need to factor in the Interest rate risk. While the fund’s value may not be susceptible to stock market volatility, it is likely to change significantly as the central bank revises the interest rates.

Factors that affect interest rate risk

A company or entity’s vulnerability to interest rate changes is inherently tied to many different factors. Some of these aspects include the following:

• Credit risk
  The credit risk measures the probability of a borrower defaulting on their debts. Increased credit risk leads to higher interest rates because lenders will aim to offset the higher risk of default by charging more interest. This, in turn, will raise borrowing costs and decrease bond prices. So, if a company’s credit rating declines, its bond prices may drop as investors will start to expect higher yields to compensate for the increased risk.
• Duration of the loan
  Typically, the longer the duration of a loan, the more it is affected by interest rates. Since bonds are essentially debts offered by the bondholders to the bond issuers, long-term bonds are more sensitive to interest rate change. This is why a 1% increase in interest rates causes a larger price dip in long-duration bonds than in short-term debt securities. So, the interest rate risk is higher for long-term bondholders.
• Forex rates
  Forex rates are the exchange rates between different currencies. Typically, this affects the values of bonds issued by companies with international debts. It also affects international debt investments. Rising interest rates may lead to currency appreciation. This, in turn, impacts the value of foreign investments. Furthermore, the converse is also true, and any adverse forex rate changes may also amplify interest rate risks.
• Market-related factors
  In addition to the above factors, many market-related drivers also influence the interest rate risk of a debt instrument. They include general economic conditions, the policies of the Reserve Bank of India (RBI) and the broad market sentiment. Inflationary pressures are also tied to the interest rate risk. If you are planning to invest in debt funds or debt instruments, you need to keep these factors in mind.

Conclusion

If you are a conservative investor, debt mutual funds can help you participate in the mutual fund market without amplifying your portfolio’s market-linked risk. However, you will still have to account for interest rate risk and other limitations of debt funds.

To reduce the impact of these risks, you could compare the mutual funds available on the Bajaj Finserv Mutual Fund Platform and select different schemes to strategically offset the limitations of debt funds. On this platform, you can browse through more than 1,000 mutual funds, filter through the options based on various parameters and identify the schemes that are the best fit for your portfolio. You can then make a lump sum investment or start a SIP in the funds you choose.

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