Ignorance and interest rates could prove a disastrous combination for investors who have money in the bond market.
Investment professionals are predicting that interest rates will start to climb this year, and that's something that can slam bond values -- no matter whether the bonds are issued by the government or corporations. But few investors seem to understand the connection, industry experts contend.
"Investors hear 'bonds' and they think 'safety,' and that's a terrible fallacy, especially when interest rates start to rise," said Andrew Stoltmann, a Chicago-based securities attorney with Maddox Hargett & Caruso. "Bonds are one of the least-understood investments around."
Indeed, recent surveys found widespread confusion about the relationship between interest rates and bond prices. The National Assn. of Securities Dealers surveyed more than 1,000 investors last year and found that 6 of 10 didn't understand that bond prices fall when interest rates rise. By the same margin, investors didn't understand that long-term bonds are more volatile than shorter-term bonds.
In a survey in January of 400 investors conducted by Kansas City, Mo.-based American Century Investments, 1 of 4 investors interviewed believed that bond prices rose when interest rates rose.
There is also confusion over volatility. The American Century poll found that 4 of 10 investors believed that the longer the bond's maturity, the less sensitive its price was to interest rate swings.
"It is important that investors understand what rising interest rates might mean to their portfolio," said Dave MacEwen, senior vice president and chief investment officer of fixed income at American Century Investments.
The NASD sent a notice to brokers last month, reminding them to better explain bond risks to customers. Bond-related complaints filed with NASD for arbitration have nearly doubled in the last two years.
"Given that interest rates are likely to rise from their current and historically low rate, NASD believes that it is imperative that investors understand the various risks, as well as the rewards, associated with debt securities," the notice said.
Things to Know
What do bond investors need to know?
First, they should be aware that interest rates and bond values almost always move in opposite directions. When interest rates fall sharply, the value of previously issued bonds can soar. That's because the the interest rate paid on those old bonds is likely to be higher than investors could get in the open market, causing the old bond to sell at a premium.
