Interest Rate Risk and Its Management

Imagine you have lent money to a friend at a fixed interest rate. Now, if the market interest rates rise, new lenders offer higher returns, making your fixed-rate loan less attractive. This situation illustrates interest rate risk — the risk that changes in interest rates will affect the value of fixed income investments.

What is Interest Rate Risk?

Interest rate risk is the risk that the value of a bond or other fixed income security will fluctuate due to changes in prevailing interest rates. When interest rates rise, bond prices fall, and vice versa. This inverse relationship affects both existing bonds and new issues in the market.

How Does Interest Rate Risk Affect Investors?

1. Price Fluctuations: When interest rates increase, existing bonds with lower coupon rates become less attractive, leading to a decline in their market prices. Conversely, falling interest rates increase bond prices.
   

2. Reinvestment Risk: When interest rates fall, investors may have to reinvest coupon payments or matured principal at lower rates, reducing overall returns.
   

3. Impact on Portfolio: Interest rate changes can affect the total return of a fixed income portfolio, influencing income and capital gains or losses.
   

Managing Interest Rate Risk:

1. Duration Management: Duration measures a bond’s sensitivity to interest rate changes. By adjusting the portfolio’s duration — either shortening it to reduce risk or lengthening it to increase potential returns — investors can manage interest rate exposure.
   

2. Diversification: Holding a mix of bonds with different maturities and coupons can help balance interest rate risk.
   

3. Use of Derivatives: Interest rate swaps, futures, and options can hedge against adverse movements in interest rates.
   

Example:

Suppose you hold a bond with a 5-year maturity and a duration of 4 years. If interest rates rise by 1%, the bond’s price may fall approximately 4%. By reducing portfolio duration, you can limit losses if rates rise.

In India, RBI’s monetary policy decisions strongly influence interest rates. Fixed income investors closely monitor these changes to adjust their portfolios accordingly. For example, a repo rate hike typically leads to higher bond yields and lower prices.

Interest rate risk is a fundamental consideration for fixed income investors. Understanding and managing this risk through tools like duration and diversification helps protect investments against market fluctuations. In the next chapter, we will explore Fixed Income Market Participants — the key players shaping this vital market.