Interest rate risk
Also written Rate risk
The risk that an investor in a debt instrument loses return because rates rise — existing instruments carrying the old, lower coupon fall in value until their yield matches the new market rate.
In plain language
A bond is a promise to pay fixed amounts on fixed dates. Nothing about that promise changes when market interest rates move. What changes is what the promise is worth.
If you hold a bond paying 8% and new bonds start paying 9.5%, nobody will buy yours at the price you paid — they can get more elsewhere. Your bond's price has to fall far enough that a buyer earns 9.5% from the remaining coupons and the redemption amount. The issuer is perfectly healthy; the coupon still arrives; you have still lost money on paper.
That is interest rate risk, and it runs in the direction people find counter-intuitive: rates up, prices down.
How it works
The price of a bond is the present value of its remaining cash flows, discounted at the market yield. Raise the yield and every term in that sum shrinks.
Two things decide how much it shrinks:
- How far the yield moved, and
- How long the money is tied up — a bond with fifteen years of coupons left has far more cash flow sitting deep in the future, where discounting bites hardest, than one maturing next year. This is what
macaulay-durationmeasures.
The consequence for a fund is that interest rate risk is not only a bond-book problem. Chapter 7 puts it more broadly: changes in rates affect an AIF's investments and the income earned on them by moving the spread between interest income and interest expenditure, and macro-economic factors acting through rates can substantially move the fund's Net Asset Value. A leveraged Category III AIF funding positions at a floating rate feels a rate rise on both sides of its book at once.
The formula
Price = Σ Coupon ÷ (1 + y)ᵗ + Redemption ÷ (1 + y)ⁿ
For a quick estimate of the damage from a small move in yield:
% change in price ≈ − Modified duration × Δy
The minus sign is the whole point. Yields and prices move in opposite directions.
A worked example
A Category II debt AIF holds Rs 100 crore face value of a five-year non-convertible debenture with an 8% annual coupon, bought at par. Six months later the RBI has tightened and comparable paper now yields 9.5%.
Discount the remaining cash flows at 9.5%:
(1.095)⁵ = 1.5742 → PV factor on redemption = 0.6352
Annuity factor = (1 − 0.6352) ÷ 0.095 = 3.8397
PV of coupons = 8 × 3.8397 = Rs 30.72 crore
PV of redemption = 100 × 0.6352 = Rs 63.52 crore
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Market value Rs 94.24 crore
The holding is marked down from Rs 100 crore to Rs 94.24 crore — a loss of Rs 5.76 crore, or 5.76%, from a 150 basis point move. That is roughly 3.8% of value per 100 basis points, which is this bond's modified duration.
The coupon has not been missed. The issuer has not defaulted. The fund's NAV is still Rs 5.76 crore lighter, and an investor redeeming this month bears it.
Hold to maturity and the Rs 100 crore comes back — but the fund has spent five years earning 8% in a 9.5% world, which is the same loss arriving slowly instead of all at once.
Why NISM asks about it
Chapter 1, section 1.4.3 gives the one-line definition among the types of risk, and Chapter 7, section 7.5 lists it as risk factor 5 in an AIF's disclosure, with the spread-and-NAV framing. Expect the direction question — what happens to the value of existing debt when rates rise — and a question separating interest rate risk from credit-risk, since both hit a bond's price but only one involves the borrower failing.
Common exam traps
- Rates up, prices down. Every year some candidates answer this backwards. The coupon is fixed; only the price can adjust.
- Interest rate risk is not credit risk. A rate-driven fall assumes the issuer pays in full. A credit-driven fall assumes it may not. A government security has no credit risk and plenty of interest rate risk.
- Longer maturity means more interest rate risk for the same yield move. A 91-day treasury bill barely moves; a fifteen-year bond moves a lot.
- "Hold to maturity" does not cancel it. It converts a mark-to-market loss into years of below-market income, and it does nothing for an investor who redeems in the meantime.
- Floating-rate instruments reprice, so their price risk is small — but the income risk moves to the holder instead. The risk shifts, it does not vanish.
- Chapter 7 frames it at fund level as a spread problem. A question about a leveraged fund is asking about both sides of the balance sheet, not just the bond book.
Where this is taught
- Series V-A · Chapter 1: Investment Landscapeintroduced here
- Series XXI-B · Chapter 4: Investing in Fixed Income Securitiesintroduced here
- Series XV · Chapter 12: Fundamentals of Risk and Returnintroduced here
- Series V-D · Chapter 1: Investment Landscapeintroduced here
- Series XIX-C · Chapter 1: Investments Landscapeintroduced here
- Series XVII · Chapter 2: Financial Markets & Investment Productsintroduced here
- Series V-B · Chapter 4: Mutual fund products for the new cadre of distributorsintroduced here
- Series XIX-E · Chapter 1: Investments Landscapeintroduced here
- Series XXI-A · Chapter 4: Investing in Fixed Income Securitiesintroduced here
- Series XIX-D · Chapter 1: Investments Landscapeintroduced here
- Series X-A · Chapter 9: Investing in Fixed Income Securitiesintroduced here
Related terms
- Credit riskThe risk that a borrower fails to meet its obligations on a debt instrument — the risk credit rating agencies exist to grade, and the one that triggers a segregated portfolio in a mutual fund.
- Market riskThe risk of loss from movements in market prices — one named category in a manager's risk framework, alongside credit, liquidity and operational risk, and the one measured with VaR and stress tests.
- RiskThe possibility that actual returns turn out different from what was expected — measured as the dispersion of returns around their own average, and not the same thing as uncertainty.
- Yield to MaturityThe single discount rate at which a bond's future coupons and redemption amount add up to exactly its market price today — the return you actually earn if you hold it to maturity.
- Macaulay durationThe weighted average time, in years, to receive a bond's cash flows, each weighted by the present value of that cash flow — the bond's effective payback period.
- Mark to MarketThe daily settlement of a futures position at that day's closing price, so gains and losses are paid in cash every evening instead of accumulating until expiry.
- Risk-free rateThe rate on a sovereign borrowing in its own currency, where credit risk is absent because the government can print the money — the benchmark every other valuation is measured against.
- Weighted average maturityThe average time to maturity of a debt portfolio, each security weighted by its share of the portfolio — a simple indicator of how sensitive a debt scheme's NAV is to interest rate changes.
- Zero coupon bondA bond that pays no coupons: it is issued below face value and repays the face value at maturity, so its duration equals its maturity.
- ImmunizationStructuring a bond portfolio so its value at a target date is protected from interest-rate changes — by matching the portfolio's duration to the liability's timing.
- Barbell strategyA bond portfolio concentrated at the short and long ends of duration with little in the middle, used when rates could move sharply in either direction.
- Term PremiumThe extra return investors demand for lending long rather than short, because a longer horizon means more uncertainty about future cash flows than money market paper of one year or less.
- Modified DurationMacaulay's duration divided by (1 + yield) — the percentage by which a bond's price moves for a one percentage point change in interest rates, and so the standard measure of interest rate risk.
- Reinvestment riskThe risk that the coupons or other intermediate cash flows from an investment have to be put back to work at a lower rate than the original investment earned, pulling the total return below the promised yield.
- Call riskThe risk that a bond is called — redeemed by the issuer before maturity. Most prevalent when interest rates fall, and it usually goes hand in hand with reinvestment risk.
- Deep Discount BondA zero-coupon bond of very long tenure, issued at a steep discount to its face value and redeemed at par. IDBI issued such bonds; the Kisan Vikas Patra is another example.
- Inverse floaterA bond whose coupon moves opposite to its reference benchmark — it pays more as market rates fall and less as they rise, the reverse of an ordinary floating-rate bond.
- Interest-rate derivativesContracts that let borrowers and investors hedge adverse interest-rate movements — interest-rate futures, interest-rate swaps, interest-rate options (caps and floors) and forward rate agreements.
- Spread riskThe risk that a floating rate security loses value because its spread over the benchmark moves adversely, even though the benchmark yield itself has not changed.
- Target Maturity FundA debt mutual fund designed to mature on a specific date, holding bonds that mature around the same time — minimising reinvestment risk and giving a more predictable return to a defined horizon.
- Liquid fundAn open-ended debt scheme investing only in debt and money market securities maturing within 91 days — among the lowest-risk mutual funds, used to park short-term surplus money.
- Credit risk fundAn open-ended debt scheme investing at least 65% of total assets in corporate bonds rated AA or below (excluding AA+) — accepting higher credit risk in pursuit of higher yields.
- Corporate Bond FundAn open-ended debt scheme that must invest at least 80 percent of total assets in corporate bonds rated AA+ and above — the higher-quality counterpart to the credit risk fund.
- Inflation Indexed BondsGovernment securities issued by the RBI whose fixed real coupon is applied to an inflation-adjusted principal, with the higher of face value and adjusted principal repaid at maturity.
- Total returnThe whole return on an investment for a period: periodic income such as interest, dividend or rent plus the gain or loss in the value of the investment itself.
- Tax-free bondsBonds issued in the past by infrastructure public sector enterprises such as HUDCO, NHAI, PFC, REC and IRFC whose interest is not taxed, so they carry a lower coupon than comparable taxable bonds.
- Sub-asset classA division within an asset class whose members share distinct features — within equity, by industry or market capitalisation; within debt, by credit risk or tenor.
- DurationA measure of how sensitive a bond's price is to changes in interest rates — the higher the duration, the larger the price swing for a given change in rates.
- Fixed income securityA debt instrument under which the issuer promises a fixed coupon at regular intervals and repayment of the face value at maturity — government bonds, corporate bonds, debentures and T-bills.
- Government SecurityA tradeable debt instrument issued by the Central Government or a State Government — treated as free of default risk, and the benchmark against which other rupee interest rates are priced.
- Inverted yield curveA yield curve on which short-term interest rates are higher than long-term rates — the reverse of the normal upward slope, read as a signal that the economy may go into recession.