I have invested in the dividend option of an income scheme. If in case the interest rates go up by 2 per cent in the next 12 months, what percentage of capital loss will I suffer?
You are evidently worried by the continuous drop in interest rates bottoming out. As bond funds have gained massively by the interest rate fall in recent years, the obvious question is what will happen when interest rates rise. While we cannot predict whether such a change will take place or not, if it happens its impact on funds' NAVs will be significant. Let's see what has happened historically when interest rates have moved up sharply.
Between January 22 and February 14, 2003, the yield on the 10-year benchmark GOI security (9.81%, 2013) went up by 91 basis points (0.91 per cent). This resulted in a 5.75 per cent fall in this security's market price. During the same period, the average bond fund lost 3.21 per cent. Similarly, when the bank rate was hiked by 1 per cent on July 21, 2000, the yields moved up by 30-40 basis points in the medium to long-end segment. The average bond fund lost 0.21 per cent that month. The worst loser in the category was down by 1.08 per cent.
For those who are relatively new to bonds, the basic relationship between interest rate and bond prices bears repeating. It's pretty straightforward: falling interest rates drive up bond prices, and rising rates cause bonds to hit the skids. Not all bonds or bond funds will fall or rise the same amount, however. The longer the duration of a bond (or the average duration of a bond fund), the more risk you assume and vice-versa. For instance, during January 22 and February 14, 2003, the yield on the 5-year bond rose by same per cent as that on the 10-year bond (91 basis points), but its market price fell less—3.95 per cent as against 5.75 per cent.
Whenever rates interest rates increase a lot will depend on your fund's duration. So keep a close watch on it if you are worried on this count.