The FINRA Investor Education Foundation recently released some troubling poll results about the “financial capability” of members of the American public.
A key aspect of their poll, which was conducted in 2012 and followed a similar survey in 2009, was a five question quiz covering everyday aspects of finance and economics.
Topics covered included compound interest, inflation, the relationship between interest rates and bond prices, the impact of a shorter mortgage term on total interest paid over the life of the loan, and diversification as it relates to risk.
In short, people did rather poorly on this quiz, averaging just three of five correct answers, and the results barely changed from 2009 to 2012. But what really stood out to me was how poorly people performed on the bond question.
Here’s the question:
If interest rates rise, what will typically happen to bond prices?
The options were that prices will rise, fall, stay the same, or that there is no relationship between interest rates and bond prices. Or people could indicate that they simply didn’t know the answer.
Out of 25k respondents, just 28% gave the correct answer — that bond prices will tend to fall as interest rates rise. In contrast, 37% of respondents said they didn’t know the answer, and 33% of respondents got it flat out wrong.
So today, I want to talk a bit about interest rates and bond prices…
Interest rates and bond prices
In short, when new bonds are issued, their rates are generally reflective of prevailing market interest rates. But once they’re issued, their rates are locked in. So…
When interest rates go up, new bonds will pay a higher rate than existing bonds that were issued at some point in the past, when interest rates were lower. Conversely, when rates go down, new bonds will pay a lower rate than existing bonds that were issued when rates were higher.
Think about what that means for a minute.
Let’s say that interest rates have increased and that you’re given the option of buying a new $1k bond or buying an older $1k bond that pays a lower rate. All else being equal, which would you prefer? The new one paying the higher rate, right?
Conversely, let’s say that interest rates have fallen and you’re given the option of buying a new $1k bond or buying an older $1k boned that pays a higher rate. As above, which would you prefer? The older one, right?
Given the above, it should come as no surprise that when rates go up, the value of existing bonds goes down. And when rates go down, the value of existing bonds goes up. Makes sense, right?
The math works the other way, too. Consider a bond mutual fund that, based on its current holdings, is paying dividends of a certain dollar amount per share. If the price per share suddenly decreases, then the yield (calculated as the dividend amount divided by the price) increases. And vice versa.
See also: Distribution Yield vs. SEC Yield
And yes, you can do the same math for individual bonds…
When rates rise, the value of your bond falls (see above) which brings its yield back into line. The payout per dollar of value for this bond — which is now worth less (but not worthless!) — should be more or less comparable to that of newer issues.
The big picture
Why does all of this matter? Well, for one thing, it feeds into the “bond bubble” talk that you’ve been hearing so much about. With interest rates at extremely low levels, there’s really only one direction that they can go. Up. And when that happens, bond prices will inevitably go down.
Should you be worried? I can’t speak for you, but I’m not panicking. We have a plan and we’re sticking to it. With a sufficiently long time horizon, these sorts of things are all just bumps in the road.