Movements in interest rates are difficult to predict. Factors such as demand for money and supply of money, risk perception of investors, inflation expectation, among others, do influence interest rates.
For a beginner, the changes in interest rates not only impact investors' preferences in future investments but also impact the prices of the bonds in existing portfolio. When interest rates go up, the price of the bond falls and when the interest rates go down the price of the bond goes up.
This can best be understood with a hypothetical example. A corporation has issued a bond for 10-years term and offered to pay an interest at the rate of 8%. One year later, the interest rates go up in the economy and the corporation again issues a new bond for nine years term at the rate of interest of 9%, then the investors’ preference for the old bond will shift to the new bond because the new bond offers higher yield. As a result, the price of the old bond will fall.
If you are holding a bond which is listed on the stock exchange, the bond prices do change in line with the changes in interest rates. For example, tax-free bond of HUDCO offering 9.01% for 20 years, was issued on January 13, 2014 at the face value of Rs 1,000. The 10-year benchmark bond yield at that time was quoting at 8.71%. Over a period of time. the interest rates fell. Now the benchmark bond yield quotes at 7.49%. The bond now quotes at a price of Rs 1,312.
When the bond yields (interest rates) move down, your bond portfolio registers capital gains. But when the bond yields (interest rates) move up, your bond portfolio offers capital losses. Prices of long-term bonds are more dependent on the changes in bond yields, compared to bonds maturing in near term.
The same applies to bond funds. A bond fund that invests in long-term bonds will see a fall in net asset value of the scheme if interest rates move up quickly.
A fund with a portfolio modified duration of 5 is expected to lose 5 percent from its NAV, if the interest rates move up by a percentage point. The other way round also holds good. The losses can be scary when the interest rates move up, especially if you are invested in long-term bond funds.
Capital losses can eat into the interest earnings on the bond portfolio. For example, when the interest rates moved up between December 2016 and September 2018, the government securities funds gave only 1.39% average returns. In the second half of calendar year 2008, when the interest rates went down quickly, the gilt funds gave 21.06% returns.
If you are worried about the possible downside arising out of interest rates moving up, you should be investing in bonds maturing in short term. In case of bond fund, one should ideally remain invested in short-term bond funds, low-duration funds and liquid funds. Go for long-term bond funds and government securities funds only if you can stomach the volatility and open to staying invested for at least five years or more.