Bonds vs Interest
75% Of Americans Got This Question Wrong
This week’s topic comes from a question in a National Financial Capability Study performed in 2024.
In the study approximately 500 individuals from each state and the District of Columbia were surveyed and, as part of the survey, the participants were posed several financial-knowledge questions.
(I’ve written about one of the questions in this study before - one that almost half of those surveyed got wrong - you can find that article here.)
As you may have gleaned from the title and subtitle, the question I’ll focus on today has to do with the relation between bonds and interest and is one that only 1 in 4 people answered correctly.
Here’s the question - do you know the answer?
If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
I’ll save the explicit answer for the end and provide some information on bonds so that if you don’t know the answer right now, you will by the time you finish reading this in a couple of minutes.
If you’ve done any investment research you may have heard that investment portfolios usually consist of stocks and bonds.
But what exactly are bonds?
Bonds are essentially IOUs issued by governments and corporations when they want to raise money.
Investors buy these IOUs and the issuing entity (government, corporation, etc.) agrees to pay the full value of the IOU back after some specified period of time, along with regular interest payments (usually twice a year).
Bonds are different from stocks in that they don’t give you any controlling interest in the entity that issues them (no voting rights, profit sharing, etc.).
Because bonds are essentially a loan, their value is less volatile than other investments - like stocks - because their value isn’t tied to the performance of the entity (as long as the entity remains financially stable enough that it can pay its debts).
So, why would anyone choose a bond over just putting money in a High Yield Savings Account or Certificate of Deposit?
Two of the main reasons for choosing bonds are:
The interest on some bonds is exempt from tax (both federal and state, depending on where you live)
Bonds can be resold on a secondary market (much like you can buy/sell a stock, you can buy/sell bonds without interacting with the issuing entity directly)
Knowing those things, now you may be asking - why would anyone choose an HYSA or CD over a Bond?
If you can avoid taxes and sell your bond at any point to access its “cash value” why lock up money in an HYSA or CD?
Well, unlike cash in an HYSA or CD, a bond is essentially you loaning your money to an entity and it comes with the risks associated with loaning money.
Some of those risks include:
Credit risk: the borrower (the government or corporation issuing the bond) could default, leaving you with nothing
Inflation risk: inflation could outpace the interest you receive from the bond while you’re “locked in” to the bond’s term
Liquidity risk: if you found yourself in need of the cash tied up in the bond and the bond didn’t have a secondary market (or there was no demand for the bond on the secondary market) you’d have no way to “cash out” early
Call risk: if the issuer of the bond redeemed it early you’d miss out on the future interest you may have been counting on
Interest risk: if interest rates rise significantly, you’re still locked into the term of the bond for its duration and will miss out on the higher interest rates that may become available via other investment channels (like a new bond or variable-rate HYSA)
Now, getting back to the question posed in the financial study, given a couple of the things outlined above - secondary markets for bonds and fluctuating interest rates - you may be able to formulate an answer to the question, if you didn’t already know the answer.
To make the answer clear, I’ll use an example.
Say you purchase a bond today for $1,000.
The bond’s term is one year with 10% annual interest.
So, if you hold the bond to maturity, you’ll have $1,100.
But let’s say you don’t hold the bond to maturity.
Instead, you decide to sell the bond next week because of an unexpected expense.
Fortunately for you, between the time you purchased the bond and when you sell it, interest rates are decreased to 1% (such a decrease may be unlikely, but it highlights the point).
Now, everyone with $1,000 to invest in bonds suddenly can only make $10 over the course of a year (1% * $1,000 = $10).
Your bond, locked in at the higher 10% interest rate, is now worth more - if someone can convince you to sell it for $1,089 (or less) they’ll make more money by purchasing and holding your bond than they would by buying and holding a “new” bond with a 1% interest rate.
So, the bond that you bought for $1,000 is now “worth” approximately $1,089 - its price increased.
This example highlights the opposite of the scenario presented in the question, but given what this example just highlighted - bond prices rise when interest rates fall - it should be relatively easy to make the mental leap to answer the original question:
If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
Drumroll…
If interest rates rise, bond prices will typically fall (because why would anyone want to purchase an “old” bond that will pay them less interest than a “new” bond with the higher interest rate?).
That’s all.
Now - go share this with all your friends and family and see how many of them are in the 25% that knew the correct answer to begin with.