Poor defence against rate risk

Suresh Krishnamurthy

AS IF the present adverse environment were not enough, fixed income investment options are now exposed to a greater degree of interest rate risk than before.

The Bank Rate is now at a level it previously touched in 1973. If rates have fallen to such levels, the probability of interest rate hikes from present levels must be considered to have increased, especially when economic activity improves.

However, investors do not have any shield to protect themselves against interest rate risk. There are no variable rate options; nor do investments offer put options.

Unfortunately, investors have to consider that the value of investments in mutual funds too will decline if rates rise. As most of the mutual fund options have higher average portfolio maturity now, the rate risk is relatively higher. In addition, as the portfolio maturities are higher, they would have to hold on to a period longer than, say, three years to reap average returns in case interest rates do rise.

The fresh inflows would mitigate the problem to an extent. But if interest rates do move up, investors would need to hold for longer periods to get returns indicated by the market now. Exiting after an interest rate spurt would diminish the returns significantly. Direct investing is not free of disadvantages either, especially of the longer-term variety. Given the prevailing low-interest rate regime, investors would be helplessly locked into lower rates if a rate rise does happen.

There are no easy solutions. However, investors can park their long-term funds in mutual funds. The risk is higher if shorter-term funds are invested in mutual funds. Similarly, funds that need to be invested with a shorter-term perspective can be parked in direct investing options, such as bank term deposits and so on.