Interest Rate Risk

The price of a bond is closely linked to the prevailing interest rate in the market. Since bonds are issued with the promise of a fixed coupon or interest rate, their attractiveness is dependent on the interest rate available on bonds of similar risk profile. Suppose a power company, Energy Grid Pvt. Ltd., issues  bonds with coupon rate of 10% and face value of INR 1000. This implies Energy Grid will pay 10% or INR 100 as coupon payment every year to its bond holders.

Suppose one year later, the market interest rate for bonds of similar risk profile is 12%. This can happen because RBI has increased the key rate at which it lends to other banks. Now the new bonds look more attractive at 12% as compared to the earlier bonds. Hence, the price of the earlier bonds offering 10% coupon will drop below the face value of INR 1000. If interest rates were to drop to 8% on similar kind of bonds, then the bonds issued by Energy Grid at 10% coupon will look more attractive than bond opportunities of similar risk available in the market. This will increase the price of these bonds and the Energy Grid bonds will start trading above par i.e. they will sell for more than INR 1000 in the market.

As you can see, bond prices have an inverse relationship with interest rates. Bond prices will fall when interest rates rise, and bond prices will rise when interest rates fall. Interest rate risk refers to this change in bond prices due to movement in interest rates. Interest rate risk is the most important risk associated with debt investments. A bond investor faces interest rate risk because the value of his/her bond holding may change with fluctuations in interest rates.

Indexation

Indexation is the process by which purchase price of assets like Gold, Real Estate and Debt Mutual Funds are adjusted to reduce the impact of inflation, while calculating return from these investments. Inflation is the gradual increase in price levels of goods and services over time, without any real increase in the value of the goods and services. For instance, a chocolate bar costing ` 50 today may cost ` 60 next year, even though there is no change to the weight or quality of the chocolate bar. This increase in price level of the chocolate bar is an example of inflation.

Here we’ll explain indexation with respect to Debt Mutual Funds since indexation benefit is applicable to Debt Mutual Fund investments that are held for more than 3 years. When you sell your Debt Mutual Fund investment after 3 years, you have to pay a tax on long-term capital gain of 20% after indexation benefit. Capital gain is calculated as the difference in the purchase price and selling price of your investment.

Suppose, you had invested ` 100,000 in a debt scheme ABC at a NAV of ` 10 three years back in Aug. 2015. You received 10,000 units of scheme ABC in return for your investment. Let’s assume the current NAV of the scheme is ` 20 and you sell all the 10,000 units at this NAV in Sept. 2018. The capital gain in this case would be the difference between the NAV at which you sold and the NAV at which you had invested 3 years back, multiplied by the number of units being sold.

Your capital gain would be = 10,000 units * ` 10 (i.e. ` 20 – ` 10) = ` 100,000

Now you need to pay a 20% LTCG (Long-Term Capital Gains Tax) on all Debt Mutual Fund investments that are held for more than three years as per current regulations.

But when indexation is applied to your capital gain, it will adjust the purchase price of your investment upward, so that the purchase NAV of Aug. 2015 reflects the impact of inflation over the three-year period. When the purchase NAV is revised upwards, it reduces the overall capital gain and thus the tax applicable.

Inflation-adjusted cost price =  Actual cost price  X  CII of sale year

CII of purchase year

CII or Cost Inflation Index is a value published by the finance ministry that is used to measure inflation. CII for 2018-19 is 280 and CII for 2015-16 is 254.

Hence, the inflation adjusted cost of acquisition would be = 100,000* (280/254) = ` 110,236

Your Long-Term Capital Gain post indexation would be, the difference in sale price and inflation adjusted purchase price = ` 200,000 – ` 110,236 = ` 89,764

Hence, you’ll now pay 20% LTCG on ` 89,764 and not on ` 100,000.

Indexation results in lower tax payout for debt Mutual Fund investments unlike traditional fixed income products like bank FDs. Thus, debt funds are more tax efficient than investments offering similar returns.

Investment Objective

The investment objective is the most important aspect of a Mutual Fund scheme that outlines the financial objective the scheme intends to achieve and spells out the level of risk it is likely to assume, while trying to achieve this objective. Thus, the investment objective of a Mutual Fund scheme helps investors decide,

  • If the scheme is suitable for their financial goal
  • The level of risk they should be comfortable with and
  • The time horizon for which investors must consider staying invested in the scheme if they plan to invest their money in the scheme

The scheme’s investment objective helps investors in deciding if the scheme is suitable for their portfolio or not. In short, the investment objective of a scheme attracts like-minded investors, who share a common investment goal and have similar risk and time horizon preferences.

The kind of securities held in a scheme’s portfolio are determined by the investment objective of the scheme. The objective could be capital appreciation over the long-term or regular income generation or capital protection or something else. The fund manager will follow an investment style that is in sync with the scheme’s stated investment objective.

For instance, the investment objective of a well-diversified equity folio may read as follows:

The investment objective of ABC Fund is to provide growth of capital plus regular dividend through a diversified portfolio of equities, fixed income securities and money market instruments.

As evident from the investment objective, ABC Fund will invest in large, mid and small-cap stocks thus providing diversification. Since the objective of this fund is capital growth along with regular income, the fund will invest in a mix of stocks and fixed income securities like bonds and money market instruments like Commercial Papers, T-bills, etc. Also, this kind of an objective would require investors to be prepared for a long holding period since investing in equities especially in the small and mid-cap segment requires at least a 5-year tenure. The scheme is likely to carry moderate to high risk since it will invest primarily in equities across capitalisation i.e. large, mid and small caps.

A Mutual Fund cannot change the investment objective of any of its scheme without prior approval from the trustees and informing the existing investors about the same. The investors are given a choice to exit the scheme without any charges within a specified period before the scheme’s investment objective can undergo a change.

Interest Rate Risk

The price of a bond is closely linked to the prevailing interest rate in the market. Since bonds are issued with the promise of a fixed coupon or interest rate, their attractiveness is dependent on the interest rate available on bonds of similar risk profile. Suppose a power company, Energy Grid Pvt. Ltd., issues bonds with coupon rate of 10% and face value of ` 1,000. This implies Energy Grid will pay 10% or ` 100 as coupon payment every year to its bond holders.

Suppose one year later, the market interest rate for bonds of similar risk profile is 12%. This can happen because RBI has increased the key rate at which it lends to other banks. Now the new bonds look more attractive at 12% as compared to the earlier bonds. Hence, the price of the earlier bonds offering 10% coupon will drop below the face value of ` 1,000. If interest rates were to drop to 8% on similar kind of bonds, then the bonds issued by Energy Grid at 10% coupon will look more attractive than bond opportunities of similar risk available in the market. This will increase the price of these bonds and the Energy Grid bonds will start trading above par i.e. they will sell for more than ` 1,000 in the market.

As you can see, bond prices have an inverse relationship with interest rates. Bond prices will fall when interest rates rise, and bond prices will rise when interest rates fall. Interest rate risk refers to this change in bond prices due to movement in interest rates. Interest rate risk is the most important risk associated with debt investments. A bond investor faces interest rate risk because the value of his/her bond holding may change with fluctuations in interest rates.