BOND, Everything Bonds Chapter 6: Bond Risks and Returns Section 2: Unraveling Interest Rate Risk & Inflation risk

In this second part of the chapter, we'll explore interest rate risk and inflation risk in the context of India, using real-life examples to illustrate their impact on bond investments

Interest Rate Risk: An Indian Perspective

Let's imagine a scenario that's all too familiar in India—buying a fixed-rate home loan. When you take out a fixed-rate home loan, you're essentially dealing with interest rate risk.

Scenario: You decide to buy your dream home and take out a fixed-rate home loan with an interest rate of 7%. At that time, this rate is competitive and fits well within your budget. You expect to make steady monthly payments over the next 20 years.

Change in Interest Rates: A few years down the line, the Reserve Bank of India (RBI) decided to increase the repo rate to control inflation. New home loans are now offered at 9%. Potential homebuyers are drawn to these new loans with lower initial rates.

Impact on Your Home Loan: While your fixed-rate home loan remains at 7%, new homebuyers can access loans at 9%. As a result, the market value of your home, should you decide to sell it, might not appreciate as quickly as homes purchased with the lower interest rates. This situation reflects how interest rate risk affects the real estate market, a concern that resonates with many Indian homeowners.

Mitigating Interest Rate Risk in India: Adjustable Rate Mortgages (ARMs)

To manage interest rate risk, some Indians opt for adjustable-rate mortgages (ARMs). Unlike fixed-rate loans, ARMs have interest rates that can fluctuate with market conditions. When interest rates rise, the interest rate on your ARM will also increase, potentially impacting your monthly payments. However, when rates fall, your payments may decrease, offering some protection against rising rates.

Inflation Risk: Keeping Up with Rising Prices

In India, dealing with inflation is a part of everyday life. Think about the price of a liter of milk or a kilogram of rice increasing steadily over the years. This real-life experience mirrors inflation risk.

Scenario: You decide to invest your savings in a fixed deposit (FD) in India, which offers a fixed interest rate of 6% per year. The interest rate seems attractive at first, but over time, inflation continues to rise at around 5%.

Impact of Inflation: While your FD offers 6% interest, the purchasing power of your money erodes due to the 5% inflation rate. The real gain in terms of what you can buy with your savings is only 1%. This common scenario exemplifies how inflation risk affects the value of your money, something that many Indians can relate to.

Mitigating Inflation Risk in India: Investing in Gold and Equities

In India, gold has long been considered a hedge against inflation. Many families invest in gold jewelry or coins as a way to protect their wealth from the eroding effects of rising prices. Similarly, investing in equities (stocks) can help combat inflation risk because, historically, the stock market has provided returns that often outpace inflation.

Understanding these risks in the context of everyday life in India is essential for prudent financial planning. By considering strategies like adjustable-rate mortgages and diversifying into assets like gold and equities, you can better navigate the challenges of interest rate risk and inflation risk while pursuing your financial goals.

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