Tuesday, July 16, 2013

Why Gilts (and bonds) are prone to interest-rate risk?

As discussed in previous blog 'Govt. Securities (Gilts) too are risky', gilts and bonds are susceptible to what in finance parlance is termed as interest-rate risk i.e. gilt and bond prices fluctuate with changes in interest rate.

Secondly, it was mentioned that the prices have an inverse relationship with interest rates. When rates fall, bond prices rise and when rates rise, bond prices fall.

Why is this so? Why are bond prices and interest rates linked...and that too inversely?

An example will answer this question.

Suppose you have a bond of Rs.100 with a coupon rate of 7.5%. Now, if the market rates were to fall to 7%, people will prefer paying somewhat higher price for such a bond as at 7.5% it offers higher returns. 

Assume that one person offers to pay you Rs.102. His returns will be Rs.7.5 on Rs.102 i.e. 7.35%, which is better than 7% presently available in the market. (Remember, the coupon rate does not change). Someone else may then offer say Rs.103, then another Rs.104 and so on. This will continue till the bond price touches Rs.107 (=7.5%/7%*100). At this price the effective return will match the market rate of 7%. No one will pay higher price than Rs.107 as beyond this their effective returns will work out less than 7%.

All this, of course, happens instantaneously. So bond prices keep fluctuating with the changes in the interest rates. Also, as you will observe, when the market rate fell from 7.5% to 7%, the bond price jumped from Rs.100 to Rs.107. (You can work out the opposite...what if market rate increases from 7.5% to 8%?)

By the way, suppose you have two bonds, one maturing after 1 year and another after 5 years. In such cases, when the rates change, then the change in price of the 5-year bond will be more than the change in price of the 1-year bond. In other words, longer the tenure, the more is the movement in the bond prices.

Summarizing, therefore:
- Bonds prices change with interest rate movement
- This change is inversely related
- Longer tenure bonds will be affected more than the shorter tenure bonds.

Accordingly, it can be very lucrative to invest in long-term gilt/gilt funds (or long term bond/bond funds) when the rates are in a declining trend. However, in a rising rate scenario it is best to stick to ultra short term funds as the impact of interest rate movement on such funds is marginal.

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