Financial Literacy Month: Bond Prices, Compounding Returns

Less than 35% of Canadians knew the right answer to basic questions around how bonds work.

Ian Tam, CFA 29 November, 2022 | 2:35PM
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The Ontario Securities Commission Investor Office recently commissioned a study to understand the financial literacy of Canadians. In a questionnaire to Canadians, a series of 27 multiple choice questions were asked. On average, investors answered just over half (53%) of the questions correctly. In this weekly Series, we answer some of the questions, and explain why they’re important.

Question: If interest rates rise, what will typically happen to bond prices?

Answer: They will fall (Only 35% of respondents got this right)

This is a particularly relevant question posed by the OSC, given the direction of travel of interest rates. Bonds are essentially an “I owe you” from a company or government looking to borrow money from you, the investor. As an investor, you would only be motivated to lend that money if you are promised repayment in the future, with interest (also known as a coupon). This coupon is linked to current interest rates, which are a tool used by a country’s central bank to help control the flow of money in the economy.

Let’s assume that you purchased a bond and were promised 2% a year for the next 10 years. After some time has passed, interest rates have gone up. New bonds from the same borrower are now paying 3% a year for 10 years. If you were to try to sell your bond, it’s likely that you would get less than what you paid for it, because the market would seek to buy the newer bonds that pay more with similar amounts of risk. Hence, when interest rates rise, bond prices fall.

Question: How do fees impact returns (with an example)?

Detailed Question: You have the choice between two mutual funds that have a total annual return of 5% before paying fees. Fund A has a MER (management expense ratio) of 1% and Fund B has a MER of 2%. If you invest $100,000 in Fund A and hold it for 20 years you will have at least…

Answer:  10 percent more than if you invested in Fund B (35% of respondents got this right, 33% said they didn’t know).

Investors love compounding returns. This very concept is what drives good investors to invest early, and invest often. A useful way to think about this question is to imagine what would happen if you were to withdraw any gains you make during a year and keep them in a locked safe somewhere. Assuming a 5% annual return on a $100,000 investment, after 20 years, you’d have $100,000 of gains in that safe, alongside the original $100,000 you invested. On the other hand, if you were to instead re-invest, at the end of 20 years you’d realize gains of $165,329 (alongside your principal of $100,000).

Investment fees (MERs) are sort of like this, but instead of you keeping that money aside in a safe, it is paid out to advisors and asset managers. The more you pay in fees, the less you have to re-invest, thus stifling the effects of compounding. 

Remember that mutual fund fees are paid to two parties (1) the advisor who sells you the mutual fund and provides advice and (2) the mutual fund company. At Morningstar, we strongly believe that good advice is well worth the fees paid, if you receive it. This might mean regular touchpoints with your advisor to help you navigate market volatility, and to help manage any life changes that result in financial impacts. If you don’t believe you’re getting value for fees, consider looking at a discount version of the mutual fund that you own, or an ETF equivalent version of the fund. Neither of these vehicles have imbedded fees for advice. 

This article does not constitute financial advice. Investors are always urged to conduct their own research before buying/selling any security.


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About Author

Ian Tam, CFA  Investment Specialist at Morningstar Canada. 


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