Everything You Need to Know about Interest Rate Risk

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Synopsis:

Interest rate risk means the risk that can be caused by the movements in the level of interest rates to the value of an investor’s portfolio. When interest rates move up, the value of fixed-rate instruments tends to decline, and vice versa. Therefore, bond investors should be careful.

Meanwhile, interest rates have an indirect relationship with the stock market. That said, interest rate changes can affect everyone, from a retail investor to a bank to an insurance company. Therefore, it is important to protect yourself against this risk.

Understanding Interest Rate Risk in Investments

Interest rate risk means the likelihood of an adverse change in the value of your investments when interest rates change in an economy. For example, when interest rates move up, the value of bonds tends to decline. Interest rates have a direct relationship with the value of bonds.

However, interest rates tend to have an indirect relationship with equities. The impact of interest rate changes can vary from one company to another. A company with zero debt and with no intention of taking a loan will not be affected by interest rate changes. However, a heavily indebted company will be affected by interest rate changes, which will also be reflected in its stock price.

In this blog, we have explained what is interest rate risk and how to manage or mitigate it. Besides, we have also given practical implications for investors to deal with interest rate risk. So, read on…

What is Interest Rate Risk?

When interest rates change in an economy, the value of investments can also change. Therefore, fluctuations in the interest rate level can expose investors to risk. Here’s how:

1. Fixed-income securities are the most at risk: When prevailing interest rates move up, the value of fixed-income securities moves down, and vice versa. Suppose you have invested in a bond which offers 5% interest per annum (p.a.) and has a face value of Rs. 1,000. Let us say that interest rates have moved up to 6% per year. However, your bond provides an interest of only 5% p.a. Therefore, its market price will move down because investors can invest in other bonds at 6% p.a.

2. Borrowing costs: When interest rates move up, it makes it difficult for companies and individuals because they have to pay a higher interest expense. If a company requires significant borrowings, its prospects will get affected due to an increase in interest rates.

Types of Interest Rate Risks  

There are four main types of interest rate risks:

  1. Re-pricing risk: When a specific asset or liability gets re-priced due to changing interest rates, it can result in re-pricing risk. Suppose you had to pay someone Rs. 1,000 five years from now at an interest of 5% p.a. But one year down the line, interest rates increase and your lender says you have to pay 6% p.a., as you had borrowed at a flexible rate. Now, your liability has been re-priced and you have to pay a higher interest.

  2. Yield curve risk: When the yield curve shifts due to changes in interest rates, it can adversely or favourably affect the price of fixed-income instruments. As already discussed, when interest rates increase, the price of fixed-income securities decreases, and vice versa. This kind of risk is known as yield curve risk.

  3. Basis risk: This risk arises when the assets and liabilities of an investor are indexed to different floating interest rates even when these assets and liabilities have the same duration. Suppose an investor has an asset which he is likely to liquidate in 3 years and a liability that he is likely to pay off in 3 years. Hence, their duration exactly matches. But if they are indexed to different floating rates, it is possible that the price of this asset and liability may not change by exactly the same amount. It could be that the asset’s price increases by lesser than the liability’s price, and vice versa. This is known as basis risk.

  4. Option risk: When interest rates change, the value of financial instruments, which have embedded options can also change. This is known as option risk. Let us take the case of callable bonds to understand this concept. These are those bonds which an issuer can call back before their term expires if interest rates fall. Suppose a company raised Rs. 1,000 through a callable bond at a 10% p.a. interest rate. A year later the interest rate falls to 8% p.a. If it is a callable bond, then this company can redeem it before the maturity date and re-issue it at 8% p.a. As a result, the investor will get only 8% interest and not 10%, which he was getting initially. This is known as option risk for that investor.

Factors Influencing Interest Rate Risk

Many factors affect interest rate risk. Find below the most important of them:

  1. General economic conditions: Prevailing economic conditions in an economy impact interest rate risk. For example, when the fiscal deficit increases, the government has to borrow more. Being the largest borrower in an economy, the government borrowings will increase the demand for money and hence will result in a higher interest rate. This, in turn, will increase interest rate risk.

  2. Inflation: Interest rates and inflation move hand-in-hand. When inflation moves up, monetary authorities increase the interest rates, and vice versa. A certain level of inflation is fine. But when inflation goes out of hand, it necessitates increasing interest rates, which results in a higher interest rate risk.

  3. Global economic conditions: The Indian economy is highly integrated with the global economy. As a result, when any changes happen in major economies like the US, Russia, Germany, Japan, etc., it may affect the Indian economy as well. For example, when crude oil prices move up internationally, domestic oil prices also increase in India, causing inflation. This can increase the interest rate risk.

  4. Indebtedness of a borrower: The more the debt or borrowings of a borrower, the more he is exposed to interest rate risk. The less the debt of a borrower, the less he is exposed to interest rate risk. This is because the higher the debt, the higher the interest expense. Therefore, any increase in interest rate will adversely affect a borrower, who has already taken a significant loan.

Managing Interest Rate Risk 

An investor can manage or mitigate his interest rate risk by using the following strategies.

  1. Diversification: Suppose an investor has invested only in fixed-rate bonds. In this case, he is exposed to a high interest rate risk because the value of these bonds will decline when interest rates move up. To mitigate it, he can invest in assets, which are less prone to interest rate risk, for example, equities. He can also have a mix of short-term and long-term fixed-rate investments. Typically, long-term fixed-rate investments are more prone to decline in value due to an increase in interest rates than short-term fixed-rate investments. Therefore, it makes sense to invest both in short-term and long-term fixed-rate investments.

  2. Hedging: A hedging strategy can help you manage or mitigate interest rate risk. Only those investors who understand hedging techniques should use this method. If you want to hedge your investments against interest rate risk, you can consider many products available in the market, for example, forward contracts, forward rate agreements, futures, swaps, options, etc.

Practical Implications for Investors

Interest rate risk has several important practical implications for investors. Understanding them can help investors in the management of their portfolios.

  1. Impact on fixed-rate instruments: As already discussed, when interest rates increase, the price of fixed-rate instruments declines, and vice versa. If an investor is heavily invested in such instruments, the best thing is to diversify by investing some portion of his portfolio in equities.

  2. Impact on stock market investments: Interest rates have an indirect impact on the stock market. When interest rates move up, it becomes more expensive for companies to borrow. Hence, if an investor has companies in his portfolio that depend significantly on debt or borrowings, then he should be watchful of those companies. A heavily indebted company may face problems when interest rates increase because its interest expense will increase, too.

  3. Impact on long-term bond investments: Typically, long-term fixed-rate bonds are more prone to changes in their value due to interest rate movements than short-term bonds. Suppose an investor has invested in a bond which offers a fixed 5% p.a interest and it matures in 20 years. If interest rates move up, the value of this bond will fall more than a bond which offers the same interest rate but matures in 5 years. This is because a longer maturity locks an investor for a longer period. Hence, investors should invest in a mix of short-term and long-term bonds.

Conclusion

This blog has thoroughly explained what is interest rate risk. This risk is a crucial risk factor for all kinds of investors because interest rates are one of the most important factors in an economy. Whether you are a retail investor or an institution, it is absolutely necessary for you to understand how changes in interest rates can affect your portfolio. Only when you understand it well will you be able to hedge against such a risk.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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Frequently Asked Questions

What is interest rate risk and why is it important for investors?

Answer Field

Interest rate risk means the likelihood of an adverse change in the value of investments due to changes in interest rates. Often an increase in interest rates results in a decrease in the value of fixed-rate instruments. This explains why interest rate risk is important for investors.

How do changes in interest rates impact investments?

Answer Field

An increase in interest rates results in a decrease in the value of fixed-rate instruments, and vice versa. However, when it comes to equities, the impact of interest rate changes can vary from company to company.

What are the types of interest rate risks investors should be aware of?

Answer Field

There are four types of interest rate risks that investors should be concerned about, which include repricing risk, yield curve risk, basis risk, and option risk.

How can investors measure and assess interest rate risk in their portfolios?

Answer Field

Investors can measure and assess interest rate risk in their portfolios by using a number of methods, including duration analysis, gap analysis, simulation analysis, and value at risk.

What strategies can investors use to mitigate interest rate risk?

Answer Field

Investors should diversify their portfolio and avoid investing in asset classes which are extremely prone to interest rate risk, for example, long-term fixed-rate instruments.

How does the economic environment influence interest rate risk?

Answer Field

In a volatile environment, typically, monetary authorities have to keep interest rates high to discourage unscrupulous entities from borrowing. Therefore, interest rates remain high and even interest rate risk is high. Conversely, in a stable environment, authorities can reduce the interest rate, as more people are able to pay back their loans, which can even reduce interest rate risk.

What are practical tips for managing interest rate risk in a volatile market?

Answer Field

In a volatile market, to deal with interest rate risk, investors should not invest too much in long-term fixed-rate instruments. Instead, they should diversify their portfolio and invest in equities and short-term instruments.

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