Explaining interest rate risk is a bit difficult, however let me try.
First of all, we need to understand to which category of investments this particular risk is applicable. As the name suggests, interest rate risk is applicable to all those investments that give us returns in the form of interest. Which are the investments that return interest? Fixed deposits, bonds and debentures are to name a few.
Basically, debt instruments are those instruments where we, as investors, lend money and in return, get interest. Upon maturity, the principal amount of these investments is returned to us.
There might arise a situation in which we may not want to wait until the maturity date and may need our money beforehand. If our investment is in fixed deposits (FD), we have to break the FD and get our principal back along with interest, if any.
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But what if these are bonds or debentures? The difference between fixed deposits and bonds/debentures is that the latter could be sold or transferred during their tenure.
It is mandatory for the issuing company to list them on the stock market; once they are listed, they can be bought and sold just as we buy and sell shares in the stock market.
FD vs bonds
What I mean to say is during the tenure of a fixed deposit, if we need funds, we can approach the financial institution to break the FD and get the principal amount back. This option is, however, not available in bonds/debentures.
During its tenure, the holder of a bond/debenture cannot get the funds back from the issuing financial institution, but can generate liquidity by trading in the stock market.
Now comes the crux of the matter. Let us assume Shashibhai has purchased bonds issued by the Government of India. These bonds are to mature after 10 years. After purchasing these bonds, Shashibai realises that he needs money to fund his daughter’s higher education and is short of money. He decides to sell the bonds in the stock market. The face value of each bond is, say, ₹100 and interest payable as per the terms of the bond when it was issued is 9.5% yearly. After he purchased these bonds, interest rates in the market increased and now the new 10-year bonds being issued in the market are offering interest at 10.25%.
Bond buyers will be reluctant to purchase Shashibhai’s bonds. However, since he needs money, he is willing to sell those ₹100 bonds at a discount – say at ₹92.50 each. As interest rates in the market had gone up, Shashibhai would have to suffer a loss.
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Similarly, if interest rates were to go down, freshly issued bonds may be available with an interest rate of 8% per annum. In such a scenario, Shashibhai will sell his bonds at a higher price and make profit. For example, a ₹100 bond may fetch him ₹105.
When interest rates go up, bond prices come down and when interest rates come down, bond prices go up. This is interest rate risk.
Principal stays
Of course, Shashibhai has the option not to sell his bonds till the end and on the maturity date, he will receive the principal amount back. In that case, there is no impact of interest rate movement on his investments and his investments are shielded from interest rate risk.
Debt mutual fund investors sometimes wonder how a debt mutual fund can give negative returns. This is because debt mutual funds have to factor in the movement of interest rates when they calculate the value of units (read NAV).
Accordingly, based on the movement of interest rates, there could be a situation wherein the bonds/debentures that a fund has invested in suffers losses and the NAV goes down.
The movement of interest rates could be due to several factors. We are not getting into those right now, but the so-called ‘secured bonds/debentures’ are also subject to risk and one of the prime risks is interest rate risk.
(The writer is a financial planner and author of Yogic Wealth)