Interest rate risk
The risk that a bond’s price falls when market interest rates rise — larger for bonds and debt funds with longer duration.
Interest rate risk is the effect of changing market interest rates on the value of fixed-income investments. When rates rise, newly issued bonds offer higher coupons, so existing bonds with lower coupons become less attractive and their prices fall. When rates fall, existing bonds gain value.
Why it matters
It affects anyone holding bonds or debt mutual funds who may sell before maturity. A debt fund’s NAV moves with the prices of the bonds it holds, so rising rates can produce short-term losses — even in a fund holding only government securities. It applies to fixed deposits in a different way: a long FD locks in today’s rate, which helps if rates later fall and limits you if they rise.
How to read it
- Modified duration is the key measure: the higher it is, the greater the sensitivity.
- Holding period. If you hold an individual bond to maturity and the issuer pays as promised, interim price moves don’t change what you receive at maturity.
- Reinvestment risk is the mirror image: when rates fall, coupons and maturing money must be reinvested at lower rates.
Common misconceptions
- “Government bonds can’t fall in value.” They have very low credit risk, but long-dated government bonds can carry substantial interest rate risk.
- “Rate moves only matter to traders.” Anyone who might need to redeem a debt fund early is exposed.
In India: The Reserve Bank of India’s policy decisions, inflation and government borrowing all influence market interest rates. CompoundX does not forecast rate movements.
Worked example
For illustration, assume a debt fund with a modified duration of 5. If yields on its holdings rise by 0.5 percentage points, its NAV could fall by roughly 2.5% from that effect alone; if they fall by 0.5 points, it could rise by roughly 2.5%.
Figures are for illustration only — not a forecast or a recommendation.
Related terms
Duration
The weighted average time, in years, to receive a bond’s cash flows — and a guide to how sensitive its price is to interest rates.
Modified duration
An estimate of how much a bond’s price changes, in percent, for a one percentage point change in interest rates.
G-Sec
Government Security
A tradeable debt instrument issued by the central or a state government to borrow money, carrying very low credit risk in the domestic market.
YTM
Yield to Maturity
The annualised return on a bond bought at today’s price and held to maturity, if every payment arrives as promised and coupons are reinvested at that rate.
Debt
Lending money in return for interest — through bonds, deposits or debt mutual funds — with returns driven mainly by interest rates and credit quality.
Maturity
The date on which a bond, deposit or other fixed-term investment ends and its principal is due to be repaid.