Why long-term bonds, not short-term? Stock market conditions are weak, interest rates decrease, real estate conditions are unfavourable

Question

Gill, Madura. Personal Finance, 4th Canadian Edition 2019. p 323.

14. Your current investment portfolio is equally diversified across stocks, bonds, and real estate. You have decided to reposition your portfolio based on your expectations about economic conditions. For the upcoming year, you expect stock market conditions to be weak, interest rates to decrease, and real estate conditions to be unfavourable. Which of the follow- investments would you most likely add to your portfolio?

a. A bond mutual fund containing bonds with short maturities
b. A stock mutual fund
c. A bond mutual fund containing bonds with long maturities
d. A real estate investment trust (REIT) fund

1. Answer on p 519 says c. Why?

2. Why isn't the answer a?

Because "interest rates to decrease"? If you buy a long-term bond now, you get the higher (compared to later) interest rate now. But if you buy a short-term bond, you must buy a new bond more quickly, and that new bond will have a lower interest?

Answer 1

The answer is incorrect, or at least severely simplified.

Consider what happens if you expect market rates to decrease by 2% and everyone else is expecting them to decrease by 3%.

Then long bonds will fall in value, if your expectation was correct.

The key here is that investing in long bonds makes sense only if you expect market rates to decrease more than everyone else expects.

Similar thing can happen in stocks. One banking stock in my country reported a cut in dividend. It didn't fall at all, because everone was expecting the same. However, one telecom stock in my country reported a cut in dividend too. Nobody was expecting that. The share fell by more than 25%.

Answer 2

If you expect the interest rates will decrease in the future, then think about it this way:

You buy a bond for 5 years that gives you a 5% interest rate.

You're assuming that 2 years from now the interest rate will be about 2%.

After 2 years, if you were right, your bond will be worth much more than the bonds with the 2% interest rate. People will be willing to pay more for your bond with that 5% rate and you will be able to sale it and earn a nice return.

If you buy a short-term bond, you will not get that advantage over others- of buying a bond when the interests were higher, and selling it when they are lower.

Answer 3

The bonds which react the most to changes in interest rate changes are the ones which mature the furthest in the future.