Interest rate risk is the risk that rising interest rates will reduce the value of existing bonds — causing NAV falls in long-duration debt mutual funds.
Bond prices and interest rates move inversely. When interest rates rise, newly issued bonds offer higher yields — making existing bonds (with lower yields) less attractive, causing their prices to fall. The longer a bond's duration, the more its price falls when rates rise. For a debt fund, this translates directly into NAV: when RBI hikes rates or bond yields spike, long-duration debt funds see sharp NAV falls. Short-duration funds are less affected because their bonds mature quickly and the proceeds can be reinvested at higher rates.
Imagine you lent money to someone at 7% interest for 10 years. Next month, the going rate rises to 8%. Your loan is now worth less to someone who could lend at 8% today. They'd only buy your loan at a discount. The same happens with bonds in a debt fund's portfolio. Long-term bonds are most affected by rate changes. Short-term bonds barely feel it.
Duration: a bond's sensitivity to rate changes. A 5-year duration bond falls ~5% for each 1% rise in interest rates.
Gilt funds and dynamic bond funds with long duration are most exposed to interest rate risk.
Liquid, overnight, and ultra-short duration funds have minimal interest rate risk.
Rising rate environment: reduce duration exposure. Falling rate environment: extend duration to benefit from capital appreciation.