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Have Money? Risk is Inevitable! [Part 2 - Interest Rate Risk]

The moment you have money...the risk begins. Inflation will start eroding its value day-by-day, year-by-year, decade-by-decade. In fact, it would wrong to use the word ‘risk’ here. Risk is something which may or may not happen. But inflation is a near certainty.

To beat inflation, earn some returns and make your money grow you have to invest it somewhere. When you so do, you are exposed to different kinds of risks depending on the product you choose.

Interest Rate Risk 

Till recent past, interest rates were fixed by Government/RBI and kept unchanged for even years together. Today practically all rates — including the post-office schemes such as POMIS, PPF, Sr. Citizen, etc. and even Savings A/c — are market determined and can change more frequently.

Consequently, the volatility of interest rates is a risk that has become an everyday phenomenon.

Fixed deposits, bonds, debt mutual funds are some of the financial instruments susceptible to interest rate risk.

Suppose, about 3 months back, you made a fixed deposit for 5 years at 8% p.a. rate of interest. The FD rates have since then increased and today you can expect even 9% p.a. rate. Thus, by locking yourselves for 5 years, you have lost the opportunity to earn higher interest. If only you had waited for a few months! This is a simple form of interest rate risk.

General awareness about the economic conditions and expected interest rate movements will help you to invest in fixed deposits at appropriate times. Thus when the likelihood is of a rate increase, you can invest in short-term deposits. Vice versa if the rates are expected to fall, you can lock-in at higher rates in the long-term deposits.

In recent times, debt mutual funds have become a preferred way of investing vis-à-vis the bank FDs due to advantageous tax policy. Therefore, you must know how the interest rate volatility affects such funds. NAVs of debt mutual funds and interest rates have an inverse relationship

Therefore, when the rates rise, the NAVs will fall. Thus, you will incur a loss. Vice-versa, when the rates fall, the NAVs will rise. Thus, you will make a profit.

Also, long term debt funds are more susceptible to interest rate movements as compared to short term debt funds.

Hence, if you closely follow the interest rate movements and time your investments correctly, you will make good profit if you invest in long term income funds when the interest rates are declining. But when the rates are rising you should invest in short-term debt funds. This way you are protected in the downturn and make money in the upturn.

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