if interest rates are expected to go up, is it logical to buy short or long term bonds? (buying only bonds)?

Question

-given the scenario that the interest rates are expected to go up and you are allowed to buy bonds only, as a portfolio manager should you buy short term or long term bonds? and why?
-how does that adverse connection between bond prices and interest rates affect this decision?

thank you in advance, this is a question asked in my money banking class.

Answer 1

If interest rates are expected to go up, bonds will go down, so no bonds would be better than either short or long bonds.

Having said that, if you must establish a position, short-term bonds would be a better investment because they will mature sooner, at which time they will be redeemed for their face value.

Long-term bonds, on the other hand, will fall in price and remain there until either rates decline once again or the bonds mature.

Answer 2

You buy short term bonds. When looking at bonds it's actually called duration. Duration is a measurement of volatility and includes the length of time.

Long term bonds are more sensitive to interest rate fluctuations than short term bonds. The reason is pretty simple, once you know why. If I have a $100 bond that is paying 6% then my bond will be worth less on the open market if new bonds are being issued at 7%. And if this bond has 20 more years until it matures, then I'll "lose" more money vs. a 7% bond than if it matures in 6 months. Therefore, someone may pay me $97 for the bond that matures in 6 months but will pay me less for the bond that matures in 20 years.

The relationship between bond price and interest rate works thusly. If you have a bond paying 5% and inflation is 3% your "real return" is 2%. But if inflation goes to 4% that return is only 1%. Therefore the bond is worth less. The longer you have it the worse off you are. Furthermore you can expect the government to raise the price they will be paying on new bonds to compensate for the rise in inflation. Which means your bond will likely be worth even less.

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Hope this helps,

Jason

Answer 3

Interest rates HAVE gone up. Bonds are not the safe haven they used to be when the market did a turn around. In the last couple of weeks, you can see that everything took a hit. Not even commodities (gold, silver, etc.) faired well. The markets are too intertwined, even the global markets are too emeshed.

So, no, bonds are not the way to go now. Best to sit tight for a bit and see what happens at the end of June. If you do decide to go with bonds, by all means nothing over 5 years, in fact 2 years may be best considering the market and how volitile it is now. What types of bonds I am not sure of now, sorry.

Answer 4

When yields go up, there is good news and bad news about bonds.

The bad news is that bonds that you own lose value when rates increase. How much value they lose is a function of many things -- but long-term bonds lose a lot more than short term bonds.

The good news is that is that any cash you receive from bonds can be reinvested at higher rates.

If you invest in very short term bonds (less than one year -- but you can get 90-day Bills) there is very little risk to your principal. When you get your money back, you can reinvest your principal at a higher rate. When rates get high enough, you can extend the maturity of your investments and lock in higher rates (or benefit from capital gains if rates fall).

In your class, you may have talked about the concept of Duration of a bond. Duration is a measure of how much the price will change for a given change in yield. When rates are rising you want to avoid long duration bonds. If you have an investment horizon, you want bonds to have a shorter duration than your time horizon. If you know they are going to fall -- you will benefit from investing in bonds with a longer duration than your horizon. If you always keep your duration equal to your investment horizon, you will be able to lock in rates. This is because the loss of principal due to rates rising is exactly offset by the increase in reinvestment income.

Answer 5

Um the fact that the bonds are longer instead of shorter would do something that might cause some sort of reaction to whatever you're talking about.

Answer 6

No.

I suggest you to stay away from bonds.

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