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Tuesday, November 13, 2001

Bonds Move in Mysterious Ways

Reported by Tony Pennino

Even though bonds and bond mutual funds are gaining renewed popularity in this time of volatile markets, most investors still do not have a strong understanding of them, at least according to the data from a new American Century survey. In a survey conducted over the telephone nationally, only four investors were able to answer correctly all 10 questions on "basic" bond I.Q. test. In 1998, only 7 respondents were able to answer all questions correctly.

Further, only 27% of respondents were able to answer at least half of the 10 questions put to them. American Century contends that this represents a drop in knowledge about bonds and bond mutual funds in the past three years.

"Even in a year when U.S. bond mutual funds are expected to outsell domestic stock funds, there continues to be a high degree of confusion and mystery surrounding bonds," argued Colleen Denzler, vice president and senior portfolio manager of American Century Investments. "Although 63% of investors correctly described a bond as a debt security issued by a company, municipality or government agency, disturbingly few understand the relationship between the direction of interest rates and bond performance, credit quality and bond yields, and bond maturity and interest-rate sensitivity."

Denzler is also concerned because a lack of knowledge of bonds could lead investors to shy away from them. "Knowledge about bonds can add value to an investor's portfolio, as classic allocation models suggest that nearly everyone needs at least some fixed-income exposure. Investors can clearly better their financial positions by learning more about bonds, whether they access the abundance of resources offered by financial service companies via the Internet or by consulting a financial advisor," she added.

Some other statistics of interest:
  • 29% believe that bond prices rise when interest rates rise, while 31% correctly knew that bond prices fall when interest rates rise;
  • 41% believe, incorrectly, that the longer bond's period of maturity the less sensitive its price is to changing interest rates (only 13% knew that the reverse is true);
  • and only 20% of those surveyed comprehend that the lower a bond's credit rating, the higher the amount of interest it pays.
Respondents, however, did score high on understanding the distinction between bonds and bond mutual funds. Most of those surveyed agreed that diversification was the better strategy to follow. 

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