Investor Corner/The asset classes/Debt Concepts
2.2.5 Interest-Rate Risk
Interest-rate risk is the risk that bond prices fall when interest rates rise, and rise when rates fall. It affects every bond to some degree, though longer-maturity and lower-coupon bonds feel it more.
Why bond prices move opposite to rates
A bond issued with a 6% coupon becomes less attractive the moment new bonds start being issued at 8%, because investors can now get a better fixed return elsewhere. The market corrects for this by pushing the price of the older, lower-coupon bond down until its yield becomes competitive with the newer ones. The reverse happens when rates fall: existing higher-coupon bonds become more attractive, and their prices rise.
When the RBI raises the repo rate, bond yields across the market tend to rise. Since bond prices move inversely to yields, existing bonds with lower coupons fall in price. The longer the bond's remaining maturity, the larger the price decline for a given change in rates. A 1% rise in yields causes a 10-year bond to fall roughly 7-8% in price, while a 2-year bond falls only about 2%. This is why duration, which measures this sensitivity precisely, is the key metric for managing interest rate risk in a bond portfolio.
Who feels this most
This risk is directly tied to duration. A long-maturity, low-coupon bond fund will feel a rate move far more sharply than an overnight or liquid fund, whose short maturities mean its holdings are constantly rolling over into whatever the current rate happens to be. This is exactly why debt funds are categorised by duration in the first place.
In India, interest rate risk is particularly relevant for investors in gilt funds, dynamic bond funds and long-duration corporate bond funds. During the 2022 rate hiking cycle, many investors who had moved into long-duration gilt funds during the low-rate environment of 2020-2021 experienced negative returns as bond prices fell. The yield they were earning on paper was overwhelmed by the capital loss from rising rates. This is the core paradox of long-duration debt investing: higher yields eventually benefit the investor through reinvestment, but the transition period of rising rates is painful.
Liquid funds and overnight funds carry almost no interest rate risk because their holdings mature within days or weeks. Ultra-short and low-duration funds have modest exposure. The risk increases progressively through short-duration, medium-duration and long-duration categories. Matching the duration of your debt allocation to your investment horizon is the most reliable way to manage this risk: if you need the money in two years, hold debt with roughly two-year duration, so that even if rates move against you, the bond portfolio will converge to its promised yield by the time you need the money.
Managing it rather than avoiding it
Interest-rate risk cannot be eliminated from bond investing, but it can be managed by matching a fund's duration to your own time horizon. Money needed soon belongs in short duration or liquid funds, which are far less exposed to rate swings. Money that can stay invested for years can reasonably take on more duration risk in exchange for typically higher long-run yields.
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For investors without a strong view on rates, a target maturity fund (which holds bonds maturing around a specific date) or a short-duration fund offers a simpler approach. The target maturity structure ensures that if held to maturity, the return approximates the portfolio YTM at the time of purchase, regardless of how rates move in the interim. It is the bond equivalent of "buy and hold" and eliminates the timing problem entirely.