IDEA OF THE INTELLIGENCE INVESTOR

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 I borrowed ₹2crs from HDFC Bank in March 2022.


I took the loan in 2 parts:

Loan 1: ₹1cr for 1yr at 6% interest, and

Loan 2: ₹1cr for 10yrs at 8% interest


For Loan 1: I will be paying ₹6lacs in interest and ₹1cr principal after a year, whereas,

for loan 2, I will be paying ₹8lacs every year for 10yrs, and ₹1cr after 10 yrs,

both are fixed-rate contracts.


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A month after issuing these loans, HDFC Bank decides to sell the loan contracts to Kotak Bank,

but how do they calculate the price?

They take the Net Present Value (or NPV) of the two contracts, using a 4% risk-free rate (Repo Rate).

Which comes to (excel link in comments):

Loan 1: ₹1.02crs
Loan 2: ₹1.32crs


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From May'22 to Oct'22, RBI hiked its interest rate by ~2%

Thus, changing the Risk-Free Rate in our NPV calculation and lowering the price of the loan contracts to (check excel file):

Loan 1: ₹1cr, down by ~1.9%
Loan 2: ₹1.15cr, down by ~13.4%

Kotak Bank makes a 2% and 13.4% capital loss on these contracts.

This phenomenon is known as Interest Rate Risk.


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Notice how the price of the 10yr loan falls much more than the 1yr loan?

Higher-maturity bonds are more sensitive to Interest Rate changes.

Interest Rate Sensitivity is calculated as follows:

Interest Rate Sensitivity = Price change/Interest Rate change

Loan 1: -1.9% / 2% = -0.95

Loan 2: -13.4% / 2% = -6.7


Interest Rate Sensitivity is always a negative number because interest rates and bond prices are negatively correlated.

For every 1% rise (or fall) in Interest Rates,

The price of Loan 1 goes down (or up) by 0.95%, and Loan 2 by 6.7%

Thus, a higher-maturity bond loses heavily in a rising interest rate environment.

 
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Why am I giving you all this "Gyaan"?

US Fed has raised interest rates at a record speed in the last 6-8 months, forcing other countries to do the same.


What are the implications of this?

Large financial institutions like:

Investment Banks,
Hedge Funds,
Pension Funds,
Retail Banks, etc

Hold long maturity bonds (10/20/30/50, even 100yrs) of their respective Govt. in huge quantities.

They even use leverage to increase their allocation to Govt bonds.

Now that Interest Rates have started to rise, these financial institutions are bleeding heavily.

e.g., a 40yr UK Govt. bond fell by nearly 75% in 12 months

Last week, the UK Govt. had to interfere and bail out a Pension Fund, which was on the brink of collapse.

Leveraged products require a daily/weekly settlement of profit & losses, aka Margin Call.

If interest rates continue to rise, these institutions will be "forced" to sell other assets (e.g., Global Equities) on their books to meet the Margin Calls, creating a domino effect across the globe.


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Given the macro backdrop, India's disconnect with Global Equity markets is a cause for concern,

While I remain invested and continue investing via SIPs, I will avoid any aggressive bets in Equities right now.


Disclaimer: Not an Investment Advice.



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