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Bonds are math. Math is hard.
Half of investors worldwide (53%) say their investment knowledge is strong, but most need a refresher course in bonds. Giving investors the facts will be critical in a period when, as recent years have shown, any hint of an interest rate hike in the US can trigger volatility in markets across the globe. The challenge for many is that the math of bonds can get complicated.
Investors are wary about rising interest rates, ranking them among the top five market risks for 2019. But few actually know what a rate hike means for their fixed income investments. Few understand that interest rate increases can have a negative impact on their bond holdings in the short term. Fewer still understand that today’s rate hike could benefit them in the long term as future income from bonds would increase. One reason for their confusion may be the inverse relationship between interest rates and bond prices.
Traditionally, the way to illustrate how rates and bonds interact is to put one at each end of a seesaw. When rates increase, there has been a corresponding decline in the price of bonds. Conversely, when rates decrease, the price of bonds has historically increased. Only 28% of those surveyed were able to identify this relationship, while 24% incorrectly answered that bond prices would increase in a rising rate environment.
Investors may be further confused by the bond math because it is actually dependent on their investment horizon. In the short run, when rates rise, bonds lose market value. But, in the longer run, those now higher rates throw off more income for the investor over time.
In terms of what a rate hike means for future income, one in five of those surveyed (19%) incorrectly assume that lower rates would mean higher income today. Few (14%) recognized that current rate hikes could actually result in higher income down the road. Only 3% of survey respondents correctly understand how bonds and interest rates are related. Six in ten respondents did not understand the relationship at all.
Given this confusing math, it’s not surprising that one-third of investors simply answered “I don’t know.” Making this relationship clear before rates increase will be critical, especially considering that among the 77% of those surveyed who invest in bonds, 54% do so to generate income while 49% are looking to reduce risk.
But not all the news on the bond front is bad. Despite failing to understand the relationship between interest rates and bond investments, 64% believe a rate hike will be good for their investments overall. More telling, however, is their self-awareness about the problem: 59% say that uncertainty on rates makes them value an experienced bond manager.