Tuesday, May 04, 2004Apparently, investors, on average, know very little about what they are doing.
Professor Bainbridge links to an LA Times article detailing the results
of a study by the NASD (National Association of Securities Dealers)
which shows how woefully incompetent the average securities investor
is. Quoting from the article:
Now, the coupon rate stays static for the life of the bond. Basically, you are getting the same annual coupon payment for the life of the bond (as with everything there are exceptions but we're keeping this simple). Meanwhile, in the real world, interest rates are changing on a daily basis. What does this mean for the investor buying bonds? Well as interest rates rise, your bond is losing value, and as they fall, the bond is gaining value. To explain why, imagine that I make a promise to give you $10 every year for the rest of my life. If we experience inflation from one year to the next, the $10 I give you can buy less than the $10 from the year before. If we experience deflation from one year to the next then the $10 I give you can buy more than the year before. If you were to try to sell my promise to someone else they will be willing to pay more or less depending on what they expect inflation to do. Bonds work the exact same way.
If a company promises to give you a 5% return on your money and the banks are offering you a 10% return on your money the rational person is going to put their money in the bank instead of buying the bonds. So, in order to avoid having to rewrite bond contracts whenever interest rates change, companies just offer the lower return bond at a discount to the face value (the principle) of the bond in order to bring returns in line with the market. So if you have a 5 year, risk free $10,000 bond at a 5% annual coupon rate and the prevailing interest rate is 10% then the bond will be issued at about $8,100. This brings the "real" return of the bond up to 10% even though the coupon rate is only 5%.
So as interest rates rise, the bonds have to be incrementally discounted to keep them in line with the market. For future buyers of these bonds this is a good trend, but for current holders it is like watching someone siphon dollar bills out of your wallet.
If you fall into the above category (of not knowing what you're doing), you probably shouldn't be managing your own money. via [Professor Bainbridge]
9:59:30 AM #
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.That is just scary. Quick primer for those of you who can manage to stay awake: As an investor, bonds are a promise to pay a sum (known as principal), on a certain date (maturity date), at a specified rate of interest (the coupon rate). Along with the coupon rate is a schedule of interest payments (typically annually or semi-annually). So let's say you buy a $10,000 bond from Incredible, Edible, Inc. with a 5% coupon rate, payable annually, that matures 5 years from today. Every year on this date (for the next 5 years) Incredible, Edible, Inc. will send you a payment of $500. On May 4th, 2009, Incredible, Edible, Inc. will pay you your last interest payment ($500) + the return of your principle ($10,000).
Now, the coupon rate stays static for the life of the bond. Basically, you are getting the same annual coupon payment for the life of the bond (as with everything there are exceptions but we're keeping this simple). Meanwhile, in the real world, interest rates are changing on a daily basis. What does this mean for the investor buying bonds? Well as interest rates rise, your bond is losing value, and as they fall, the bond is gaining value. To explain why, imagine that I make a promise to give you $10 every year for the rest of my life. If we experience inflation from one year to the next, the $10 I give you can buy less than the $10 from the year before. If we experience deflation from one year to the next then the $10 I give you can buy more than the year before. If you were to try to sell my promise to someone else they will be willing to pay more or less depending on what they expect inflation to do. Bonds work the exact same way.
If a company promises to give you a 5% return on your money and the banks are offering you a 10% return on your money the rational person is going to put their money in the bank instead of buying the bonds. So, in order to avoid having to rewrite bond contracts whenever interest rates change, companies just offer the lower return bond at a discount to the face value (the principle) of the bond in order to bring returns in line with the market. So if you have a 5 year, risk free $10,000 bond at a 5% annual coupon rate and the prevailing interest rate is 10% then the bond will be issued at about $8,100. This brings the "real" return of the bond up to 10% even though the coupon rate is only 5%.
So as interest rates rise, the bonds have to be incrementally discounted to keep them in line with the market. For future buyers of these bonds this is a good trend, but for current holders it is like watching someone siphon dollar bills out of your wallet.
If you fall into the above category (of not knowing what you're doing), you probably shouldn't be managing your own money. via [Professor Bainbridge]
9:59:30 AM #
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