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Bond Literacy Quiz

January 24th, 2014

Bond Literacy Quiz

The 30 year bull market for bonds has created a tremendous amount of confusion for both financial advisors and individual investors.  I developed this quiz as a way for individuals to test their knowledge about an asset class that is widely used and highly misunderstood.  The answers are at the end of the quiz.

  1. 1.
    1. a.True
    2. b.False

 

  1. 2.Bond funds help investors protect their wealth from rising inflation.
    1. a.True
    2. b.False
  1. 3.TIPS (treasury inflation protected securities) are a great way to protect my wealth from rising interest rates.
    1. a.True
    2. b.False

 

  1. 4.Bond prices:
    1. a.Move in tandem with interest rates
    2. b.Move opposite of interest rates
    3. c.Are not affected by interest rates
    4. d.Are only affected by large interest rate movements, of 100 basis points or more

 

  1. 5.A government bond fund, with triple A rated securities:
    1. a.Could lose over 30% in one year
    2. b.Will never lose more than 10% in one year
    3. c.AAA rated bonds backed by the U.S. Government never lose money

 

  1. 6.Tightening Spreads will cause a corporate bond fund to:
    1. a.Lose money
    2. b.Make money
    3. c.Spreads have no impact on bonds

 

  1. 7.Duration measures:
    1. a.The first derivative of the price of a bond with respect to interest rates
    2. b.How long your bond has been held in the mutual fund
    3. c.The length of time before your bond pays you the first coupon

 

  1. 8.A bond fund with a duration of 10:
    1. a.Will pay 10% interest
    2. b.Will lose 20% if interest rates go up by 200 basis points
    3. c.Has less risk than bond fund withduration of 5
    4. d.Will not be impacted by interest rate swings

 

  1. 9.If I buy conservative bond funds:
    1. a.I could lose money, potentially for many years
    2. b.I might not make much money, but will never lose
    3. c.May only lose for a month or so, but as long as I hold the fund I will be ok in the long run

 

  1. 10.Emerging markets bond funds:
    1. a.Are an important diversification tool I should always own
    2. b.Could plunge by over 30% and not recover for a decade
    3. c.Should make about 12% per year due to the high growth of emerging markets

 

ANSWERS

 

  1. 1.False.  If the inflation rate exceeds the bond’s yield for the time you hold the bond, you will loseFor example, you purchase a 10 year treasury bond at a yield of 2.50% and hold it until maturity.  During that time inflation averages 3%.  You end up losing .50% per year due to inflation.

 

  1. 2.False.  Bonds are a very poor choice to protect one’s wealth fromInflation can rise above a bond or bond fund’s yield and erode one’s principal.

 

  1. 3.False.  Tips currently have extremely low coupons (approximately .625% for a 10 year security).  If interest rates rise in the years ahead (say by several percentage points), then the bond’s price will drop significantly due to rising rates.  Should the investor need to liquidate the bond prior to maturity, massive losses could be incurred. Additionally, if inflation remains modest, but interest rates rise substantially (i.e. real rates rise) TIPS will exhibit market losses prior to maturity and provide no real return when they mature, returning only the inflationary gains to the investor at maturity.  

 

  1. 4.Bond prices move opposite to interest rates

 

  1. 5.Could lose over 30% in one year.  For example, the Vanguard Long Term Treasury Investor Fund (VUSTX) has a duration of 15.3.  If long term treasury yields were to rise by 3% (300 basis points) the fund would lose approximately 45%. 

 

  1. 6.Make money.  A spread is the extra yield (in basis points) that a corporate bond will pay over and above the comparable term Treasury bond.  When spreads tighten, the extra yield over the treasury is diminishing (this often happens as the economy is improving and default expectations are reduced).  As the spread tightens, the corporate bond will experience and increase in price.

 

  1. 7.The first derivative of the price of a bond with respect to interest rates.

 

  1. 8.Will lose 20% if interest rates go up by 200 basis points.  See answer to question 7.

 

  1. 9.I could lose money, potentially for many years.  While a bond fund may be labeled as “conservative” the fund can indeed lose money during a protracted period of rising rates.  For example, if interest rates continually rise over the next five years from a level of 2.80 on the 10 year treasury to say 9% five years from now, a “conservative” bond fund that invests predominantly in these securities may turn out to be a perennial loser.

 

  1. 10.Could plunge by over 30% and not recover for a decade.  Many of today’s asset allocation recommendations include a serving of emerging markets bonds in the pie chart.  While there can be some diversification benefits associated with this asset class, emerging markets bonds are not appropriate for all portfolios and can experience dramatic losses.  These complex investments are susceptible to many different risks ranging from liquidity, country specific credit and currency issues to interest rates and inflation. 

           

 

About the author of this quiz.

Ethan S. Braid, CFA is the founder of HighPass Asset Management – an independent, fee-only, registered investment advisory firm with a fiduciary duty to the clients it serves.  Mr. Braid has been passionate about managing client investment portfolios and providing customized financial planning advice since he started working in the investment industry 14 years ago. Mr. Braid earned a BS in Finance from Robert Morris University, an MBA from Cleveland State University and he is also a CFA Charterholder.

Mr. Braid is devoted to being an expert in the field of wealth management for high net worth individuals and families and for many years, has read one book per month on subject areas such as:  estate planning, retirement planning, investment analysis, mergers & acquisitions and behavioural finance.  Mr Braid also has a passion for business history with a focus on the late 19th & early 20th centuries.

When Mr. Braid is not helping clients, he enjoys: cooking, wine, exercise, his yellow Labrador retriever, fly fishing, hiking, travel, playing guitar, snowboarding and duck hunting.  Mr. Braid is a committee member of the Denver Chapter of Ducks Unlimited.

This article is provided by HighPass Asset Management for informational purposes only.  No portion of this commentary is to be construed as a solicitation to buy or sell a security or the provision of personalized investment or legal advice.