Question

As you read the business news, you come across an advertisement for a bond mutual fund – a fund that pools the investments from a large number of people and then purchases bonds, giving the individuals “shares” in the fund.

The company claims their fund has had a return of 13½ percent over the last year. But you remember that interest rates have been pretty low – 5 percent at most.

A quick check of the numbers in the business section you’re holding tells you that your recollection is correct.

Explain the logic behind the mutual fund’s claim in the advertisement.

Answer 1

As you read the business news, you come across an advertisement for a bond mutual fund – a fund that pools the investments from a large number of people and then purchases bonds, giving the individuals “shares” in the fund.

The company claims their fund has had a return of 13½ percent over the last year. But you remember that interest rates have been pretty low – 5 percent at most.

A quick check of the numbers in the business section you’re holding tells you that your recollection is correct.

Explain the logic behind the mutual fund’s claim in the advertisement.

Answer: The high return can be described in two ways. The first is that the mutual fund is invested in highly volatile debt and is being rewarded for taking this risk with higher returns. The second is that the fund kept securities during the time when interest rates were declining, so the yield on the holding period much surpassed the interest rate. Remember that bond prices increase as interest rates drop, giving the buyer a capital gain. When interest rates are now small, then they are likely to rise, causing the owners to lose money. The high return may be a function of the fall in the rate of interest, and not only will it not be replicated, but the low or even negative return will likely be accompanied by an increase in interest rates.