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.

Sears Bond 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.

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