5. What is Interest Rate Risk?
Interest Rate risk is another important type of risk that impacts the value of various securities along with some Mutual Funds. Thus, before going any further, it’s crucial to understand what an Interest Rate is.
“Interest Rate is the cost of borrowing money”
For example, Jahan borrowed Rs. 100,000 from Meezan Bank. He has to return the money back in 1 year. Since the bank is lending money to Jahan and not investing it elsewhere, the bank needs some extra benefit. Jahan has to pay an additional cost of borrowing Rs. 100,000 i.e. an interest rate of 2%. This means that Jahan’s cost of borrowing is 2% * 100,000 or Rs. 2,000. At the end of one year, Jahan will return Rs. 100,000 plus an additional Rs. 2,000 to the Meezan Bank.
You must have heard about the word “Bond.” A bond is a type of security that pays you interest. Government, public companies and private companies are allowed to issue bonds in Pakistan. These institutions may need money from investors to invest in infrastructure, inventory, plant, machinery or building. Remember from Chapter 1 that corporations issue stock to raise capital and pay you dividends in return. Similarly, institutions issue bonds to raise capital and pay the return in the form of ‘interest.’ Bonds are also called debt instruments or fixed-income instruments.
Consider two securities: Bond A and Bond B
- Bond A was issued to investors in December 2016 at a price of Rs. 1000. Bond A’s interest rate (also called Coupon Rate) is 8%. This implies that if an investor is willing to invest his money in this bond, he will get the initial funds plus an additional 8% back which is Rs. 80. Two points to note here: the 8% interest rate is fixed and the life of the bond is 10 years which means investors will get their initial funds plus interest back in 10 year.
- Another bond called Bond B was issued recently offering an interest rate of 10% and the life of this bond is also 10 years. From investors’ perspective, Bond B is more attractive as it pays 10% interest rate compared to the lower 8% rate offered by Bond A. Since the interest rate is fixed, the price of bond A will have to fall to make it more attractive. In other words, Bond A will have to be offered on a discount.
- The entire economy will have thousands of such bonds and other fixed income instruments. It’s difficult to know whether Bond A’s price will be impacted by Bond B’s interest rate or Bond C or your bank’s deposit rate. Therefore, we use a general market interest rate which is determined by the Central Bank or State Bank of Pakistan.
- Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, the fixed interest rate of a bond becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. The key takeaway is that:
"As market interest rates rise, prices of bonds fall and vice versa"
If a mutual fund invests in fixed income instruments, it’s value will also change with interest rate fluctuations. If market interest rate rises, the value of underlying fixed income securities will fall and consequently, the NAV of the mutual fund will decline.