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

If the interest rates to decrease in the future, then think about it like this:

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

You're assuming that in 2 years the interest rate will be as low as 2%.

After 2 years, if you were right, your bond will 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 and earn a great return.

If you buy a short-term bond, you don't get that advantage over others, of buying a bond when the interests were higher.

Answer 2

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