Interest Rate Risk

The inverse relationship between bond prices and interest rates is one of the most fundamental principles of fixed income. When market interest rates rise above the coupon rate of an existing bond, the bond becomes less attractive relative to newly issued bonds offering higher coupons, causing its price to fall until the yield-to-maturity aligns with prevailing market rates. Conversely, when market rates fall below a bond's coupon rate, the bond's price rises. This price sensitivity to interest rate changes is quantified by the duration metric — specifically, modified duration — which measures the approximate percentage change in a bond's price for a 1% change in interest rates.

In India, the primary driver of interest rate risk in the bond market was the Reserve Bank of India's monetary policy decisions. When the RBI's Monetary Policy Committee raised the repo rate — as it did in a series of increases totalling 250 basis points between May 2022 and February 2023 in response to elevated inflation — existing bond prices fell across the yield curve. The 10-year Government of India (G-Sec) benchmark yield moved from approximately 6.8% in April 2022 to above 7.4% by mid-2022, reflecting the rate hike cycle. Bond portfolios with long duration exposures, particularly those held by gilt mutual fund categories and long-duration debt fund categories, saw net asset values decline as yields rose.

The degree of interest rate risk in a portfolio was captured by its duration profile. A portfolio with a modified duration of 7 years would lose approximately 7% in NAV for every 1% rise in interest rates, all else equal. This made long-duration gilt funds appropriate for investors who held the view that interest rates were near a peak and were positioned to benefit from rate cuts, but the same funds carried significant mark-to-market risk for those who held them during a rate hike cycle. SEBI's mutual fund categorisation framework required debt funds to disclose duration bands, helping investors understand and select duration risk profiles appropriate to their investment horizon.

For banks and NBFCs, interest rate risk manifested in the Asset-Liability Management (ALM) framework. A bank with fixed-rate long-term loans funded by variable-rate short-term deposits was exposed to net interest margin compression if short-term rates rose faster than long-term rates. The RBI required banks to maintain detailed ALM statements disclosing the maturity profile of assets and liabilities, and banks ran duration gap analysis to quantify how much their net interest income would change under various rate scenarios. Banks with a positive duration gap — assets longer in duration than liabilities — benefited from falling rates but suffered from rising rates, and vice versa.

Retail investors encountered interest rate risk most directly through debt mutual funds. Funds in the long-duration, gilt, and dynamic bond categories carried the highest interest rate risk, while overnight, liquid, and ultra-short-duration categories had minimal exposure. Understanding duration before selecting a debt fund was essential for aligning the fund's risk profile with the investor's time horizon and yield outlook.