Bond Quiz

After my recent post arguing that Owning Today’s Long-Term Bonds is Crazy, I got a lot of thoughtful reaction, but I also found that many people are confused about how bonds work.  So, I’ve put together a short quiz to test your bond savvy.

For each of these questions, we assume that you have just invested $10,000 in a 30-year government bond paying 1.2% interest.

1. What payments will you get from this bond if you hold it for the full 30 years?

a) It depends on how the consumer price index changes over the years.
b) You get $120 each year for 30 years, and at the end you get your $10,000 back.
c) It depends on how interest rates change over the 30 years.


2. If interest rates rise, what will happen to your annual interest payments?

a) They will go up.
b) They will stay the same.
c) They will go down.


3. If interest rates fall, what will happen to the resale value of your bond?

a) It will go up.
b) It will stay the same.
c) It will go down.


4. Suppose interest rates rise over the next decade.  In 10 years you sell your bond and use the proceeds to buy a new 20-year bond paying 3% interest.  What will your 30-year compound average return over the 30 years be if you hold the new bond to maturity?

a) below 1.2%
b) about 1.2%
c) above 1.2%


Answers below

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1. b) Bond payments are fixed.  There are special bonds that adjust to inflation, but this isn’t true of regular bonds.  If interest rates change, your payments stay the same.  Some investors seem to think that owning a bond is similar to a savings account whose interest payments rise and fall over the years.  This isn’t true for bonds.

2. b) Bond interest payments stay the same no matter how interest rates change.  The interest rate paid by new bonds will be higher, but old bonds don’t change.

3. a) When interest rates fall, your bond keeps paying the same interest payments.  These payments will be higher than the interest payment on new bonds.  So, investors will be willing to pay extra to buy your bond.

4. b) At any given moment, all government bonds with the same duration (number years left) are priced to be equally desirable.  The ones with high interest payments will trade for more than ones with low interest payments.  So, when you sell your bond that pays only 1.2%, you’ll get less than $10,000 for it.  The amount less will compensate for it not paying the current going rate of 3%.  So, you’re not gaining or losing much trading your bond for another bond of the same duration.  You’ll get more interest for the next 20 years, but you’ll get less back at the end.  The 1.2% interest rate you accepted initially stays with you, even if you trade for a higher interest rate bond.

It’s easy to lose sight of these bond lessons when you own a government bond ETF, but they still apply.  When you buy the ETF, you’re locking in your nominal return for the duration of each bond in the fund.  Trading between bonds of the same remaining duration can’t change this.  Trading to bonds with different remaining durations can only make a limited difference.  Prevailing interest rates when you buy into long-term bonds are hard to escape for decades.

Comments

  1. AnonymousNovember 14, 2020 at 10:05 AM

    "Trading between bonds of the same remaining duration can’t change this. Trading to bonds with different remaining durations can only make a limited difference"

    About trading to bonds with different remaining durations to icnrease return, you would have to be able to predict interest rates better than the market. That is difficult. That assumes only interest rate risk in the bonds you own.

    ReplyDelete
    Replies
    1. Michael JamesNovember 14, 2020 at 10:30 AM

      Anonymous,

      It's true that trading to bonds with different durations is no guarantee of improving returns. The main scenario where you might be able to help yourself is if interest rates start to rise and you sell your long-term bond to buy short-term bonds. Then if rates continue to rise, you'll do better than you would have if you stuck with the long-term bond. However, your average return over the full period from buying the long-term bond until it expires would still be heavily influenced by the poor return offered by the long-term bond.

      As you said, this attempt to get out of the crappy long-term bond return depends on predicting interest rates better than the market. So, it's very hard to do and the results would still be unsatisfactory. This makes the choice to buy the long-term bond a poor one in the first place.

      Delete

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