FINRA (the Financial Industry Regulatory Authority) periodically surveys people about their financial knowledge. It asks respondents to rate themselves as to how financially knowledgeable they think they are. In 2015 76% of people rated themselves as having a “high” level of financial knowledge, giving themselves a score of 5 to 7 on a 7 point scale. (And if they are sitting around taking a FINRA test voluntarily, they must really be into finance). Then the survey asks 5 questions about financial situations that may be encountered in everyday life. One question in particular was answered incorrectly by more than 7 out of 10 people – and again the vast majority of people thought they were highly knowledgeable. Are you curious as to what the question was that so many people missed? Here it is:
If interest rates rise, what will typically happen to bond prices?
(a) They will rise (b) They will fall (c) They will stay the same (d) There is no relationship between bond prices and the interest rate.
The correct answer is (b) They will fall. We call this interest rate risk. As interest rates rise, bond values fall. This applies whether it is an individual bond or a bond fund. Here is a quick example:
Let’s say you own a $100,000 bond paying 3%. But then you retire and need to sell some of that $100,000 bond to live on. But interest rates have risen to 5% since you bought it, and now your 3% bond isn’t as valuable because other companies are paying 5%. So you have to sell your $100,000 bond for less than you paid for it.
In retirement we sell investments – either because we need the income, or because the IRS comes knocking at age 70 1⁄2 and forces us to sell IRA investments to satisfy the annual withdrawal rules. Look ahead 5 and 10 years. If you think interest rates will be higher, you’ll be looking at bond losses.
Choosing the right bond mix for your portfolio is paramount. Finding the balance between the length of maturity, the yields, the credit quality and the inherent interest rate risk needs deliberate thought and strategies.