Bond Prices Go Down When Interest Rates Go Up

A headline in the Boston Globe caught my eye the other day. Study says many Americans are in the dark on basic financial concepts. It turned out to be old news, about a study from FINRA that came out about six weeks ago.

But there was one tidbit the Globe highlighted that I had missed last month. When asked "If interest rates rise, what will typically happen to bond prices?" only 21% of Americans got the right answer, that they will fall.

Now I am, to say the least, not easily surprised by financial ignorance, but 21% correct on a multiple choice question with essentially two choices is pretty amazing. Even if you allow for a third possibility, that bond prices neither go up nor down but stay the same, 21% is still well below the monkeys and dartboards threshold of 33%.

Actually, the most popular answer, at 34%, was a refreshingly honest "don’t know." Once you exclude the candidly ignorant, the breakdown was close to the monkeys, up/down/neither being 20%/21%/24%.

But even that’s not quite true. The 24% above is a combination of 8% who said bond prices will stay the same and 16% who said "there is no relationship between bond prices and the interest rate." So by inference the 8% think that bond prices and interest rates are related, but not so much that you’d, you know, see a relationship between them.

Among finance types like me, the fact that bond prices and interest rates move in opposite directions is so fundamental and obvious that it is used as a punch line. If you want to joke that an investor is particularly unsophisticated or stupid you imply that understanding bond prices vs. interest rates is the limit of their knowledge. (Saying that they didn’t understand even that would be too absurd and therefore unfunny.)

Why is this question so hard for ordinary non-finance types? I think the tricky part is not interest rates as an inverse price but the idea that bonds have prices at all. Most Americans are familiar with trading in stocks. Even if they have never done it themselves, they’ve heard plenty about on TV, in the movies, and probably from their friends.

Bonds, on the other hand, are alien territory for most people and the idea that they trade, with prices that change every day, in a way similar to stocks is a bit of a surprise. But the idea that when interest rates go up existing bonds paying the old lower rates are worth less is not, or should not, be all that hard to explain.

When a new iPhone comes out with additional features, the older ones lose value. It is just the same with Treasury bonds. When new ones come out paying 4%, the old ones that paid 3.5% look kinda lame. So to get anybody to buy them, they need to be marked down. In fact, the discount needs to be big enough that you would make the same amount of money from the new 4% ones and the on-sale 3.5% ones.

The opposite is true if interest rates fall. If the new bonds pay only 3%, then the old ones still paying 3.5% seem totally hip in a retro sort of way. So they will rise in price until a buyer would be indifferent between the rare vintage bonds and the uncool new ones.

That wasn’t so hard, was it? You now understand more about the relationship between interest rates and bond prices than, apparently, just about everybody else.

Then again, from a personal finance standpoint, ignorance of bond pricing is not necessarily a symptom of anything wrong. Many people, maybe most people, will go their entire lives without needing to buy or sell a bond. They might own a mutual fund that invests in bonds, and might therefore appreciate knowing why it loses value when rates go up, but that’s about it. As elementally obvious as it is on Wall Street, on Main Street it is almost trivia.

So I’ll give the monkeys a pass. This time.

Investing, Media | Frank Curmudgeon | January 18, 2010 12:59 pm

102 Comments

By Jim, January 18, 2010 @ 1:46 pm

I didn’t know much at all about bonds until a year or two ago when I started reading up on them. Now the relationship between bond price and interest seems obvious to me. But I honesty can’t say if I’d gotten the question right a few years ago. I’m betting most people don’t know bonds are traded on the secondary market.
By Adam, January 18, 2010 @ 2:48 pm

Wow, I had a manager from the underwriting department of my company come into my office JUST this morning asking for help on a presentation. He wanted to know what would happen to our equity reserves if interest rates went up 400 basis points in a year. I told him it would have a significant impact on our investment portfolio, since it was all fixed interest holdings. He said, “Oh, so we’d have more money?”

After I smacked my forehead and explained that no, we’d lose about 12% of our equity, it dawned on me that non-finace people think that if you hold interest bearing investments and interest rates go up, they think your investments must go up too. They don’t understand that the rates are fixed and you’ve already paid for it, like your iPod analogy (which is spot on and I might borrow).

Good post!
By Neil, January 18, 2010 @ 3:00 pm

While it’s wrong, I can understand the “no relationship” crowd. I mean, if you’ve never issued or purchased a bond, you’ll probably think of them as “a $1000 bond is a $1000 bond, right?” Which makes sense if you’re only thinking of them in buy-and-hold terms. So that intuitive leap can certainly explain why monkeys might do better on this question.
By Larry, January 18, 2010 @ 3:27 pm

…it dawned on me that non-finace people think that if you hold interest bearing investments and interest rates go up, they think your investments must go up too…

They may be drawing an analogy with interest in a savings account. Personally I find bonds a lot harder to understand than stocks.
By Mike Piper, January 18, 2010 @ 3:34 pm

My initial thought about the survey results were “unsurprising, yet terrible.”

After I actually looked at the survey though, I have to wonder how accurately people represented their knowledge. It’s a very long phone survey, and the questions about interest rates and bond prices come near to the end.

I know if I were the person on the phone at that point, my attention span would be shot, and I’d be at least slightly inclined to give whatever answer popped into mind fastest just to get the thing over with.
By Mr. ToughMoneyLove, January 18, 2010 @ 4:12 pm

I don’t think most people understand the concept of buying and selling bonds on the secondary market. To most, a “bond” is something you buy from the issuer and hold until it matures. Thus, the idea that a bond will fluctuate in price doesn’t connect with them.
By RetirementInvestingToday, January 18, 2010 @ 5:01 pm

Maybe a more appropriate question today would be what happens to Bond prices once Governments stop buying their own debt through Quantitative Easing?
By Rick Francis, January 18, 2010 @ 5:04 pm

Frank,
It doesn’t surprise me too much… If an ordinary person buys a bond they likely bought a zero-coupon savings bond. It’s also likely it was a gift so they never tried to sell any bonds before maturity. The payout doesn’t change so it appears the bond’s value is independent of the current interest rate.

I understand bond prices will go down if interest rates go up…which is why I’m hesitant to buy medium or long term bonds. With interest rates at historically low levels and government spending at historically high levels, how can interest rates NOT increase soon?

-Rick Francis
By Jim, January 18, 2010 @ 5:44 pm

I think Rick is right that most peoples knowledge of bonds is limited to US savings bonds which are treated as fixed value.

I wonder if some people confused the market price of a bond with the face value of the coupon? If you buy a $25,000 bond from Sears like the one pictured then its still got the same $25,000 face value regardless of interest rate fluctuations.
By Chris, January 19, 2010 @ 1:30 pm

I would like to build on Jim’s comment.

About a year ago, I had some money that I knew I would need in about a year but interest rates on CD’s and Money Market funds were dismal. But, there were several corporate bonds that had higher yields, attractive risk ratings, and that would mature right around when I would need my money. It was really hard for me to wrap my head around the prices on the bonds and whether or not they were a good investment. The effective yield at the end seemed good but the fluctuations in the middle confused me.
By Susan Tiner, January 20, 2010 @ 3:35 pm

I love the iPhone analogy, but disagree that knowledge of bond prices and interest rates is a matter of trivia on Main Street. Per my latest post, I think we need to not wait until second-semester calculation to formally introduce time value of money concepts.
By Susan Tiner, January 20, 2010 @ 10:20 pm

That should be second-semester calculus, not calculation!
By RT, January 21, 2010 @ 6:39 pm

To be honest, I’m not terribly surprised that people don’t understand bonds. They’re not popularized by the media the way stocks are, and they’re not part of any school’s (up through the undergraduate level at college) general curriculum. So how would people know about them?

My answer: People who want to know about finance will eventually find that information.
By Paul, August 11, 2010 @ 5:16 pm

What surprises me most about what I see written about bonds is that it appears to be written to an audience that is not expected to hold them to maturity. I guess they either speculate on interim values or are somehow compelled to sell before maturity.

I’m sure many bond investors, myself included, invest in bonds/bond funds for the income they generate and with the expectation that the bonds will be held to maturity. This makes interim prices moot, and rising interest rates good: maturing bonds roll over into issues that yield more.
By Lonnie, October 7, 2010 @ 9:30 pm

People don’t take the time to understand things and base their opinions on opinion more than anything else
By johnny, November 1, 2010 @ 5:23 pm

Couldn’t agree more.. but that is what annoys me more than anything. Some people need to grow some and form their own opinions on what they see/read and not listen to everyone else.
By James T., November 2, 2011 @ 2:01 pm

I take nobody’s opinions. I’m moved by my own “gut feelings” and it’s always proven well to live my life like that
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