The price of a bond varies inversely with the market yield… by definition!”

That’s what the professor said on our first day of finance class many years ago. It took a few months of studying “present value concepts” — the time value of money — to confirm that he was right. In simpler terms, he said that as current interest rates increase in the market, the price of existing bonds must decrease… and vice versa.

The recent growth in the mutual fund industry has brought in many unsophisticated investors: in other words, people who don’t understand what the professor said. This was evidenced by a recently published survey of mutual fund investors. One of the survey questions addressed the professor’s point and the majority “failed” the test. Their line of reasoning is that a bond or mortgage fund invests in “things” that earn interest. So, if interest rates rise, that must be a good thing! In fact, it is the opposite.

The reason for this falls back on first year finance class. Imagine you buy a $1000 bond at par which will pay interest at 10% for two years. At the end of year one, you receive a cheque for $100. Now, imagine that interest rates have moved up and new bonds are paying 12%. Furthermore, imagine that you have to sell the bond at the end of the first year to go on a holiday. No one will be interested in buying your bond — it only pays 10% while others are paying 12%. The only way you can entice a buyer for your bond is to sell it for less than $1000. This “discount” will make up the extra amount needed to earn 12%, because the new buyer will recover the full, original $1000 you invested in one more year.

The buyer will spend $Y today to receive $1100 in one year and wishes to make 12%.

1.12 x $Y = $1100

So, Y = $982

The buyer earns 12% and you get your holiday; unfortunately, along the way you lost $18, for a net return of $82 (100-18), or 8.2% — less than the 10% you thought you were getting.

So, as interest rates drop, bond fund prices increase, giving substantial returns. However, when interest rates hit the bottom, eventually they only have one way to go — up — and that means that bond prices will decrease.

Thank you, professor!