When economic is getting worse, the interest rate is expected to go down. Is it better to invest in short term or long term bond ?
Consider this: when interest rates are expected to decline, do you want your (modified, or effective) duration to be long or short?
Answer that and you’ll have the answer to your question.
The answer is “it depends”.
What is your investment horizon? If you are willing to hold the bond until its maturity, then you just expect interest income. So a long-term bond is suitable in any interest rate scenario. A short-term bond will also work. (remember the face value of a bond is fixed by contract, unless I get a default from issuer).
The problem originates when you are not willing to hold the bond until its maturity. The thing here is the bond price. Interest rates and bond prices are inversely related, so if interest rates are expected to decrease, bond prices are expected to increase and vice versa. So, if rates are going to fall, you can buy a bond today and expect its price to increase so you get a capital gain on the bond investment (plus the interest income). The question is… what kind of bond is more sensitive to interest rates, long-term or short-term bonds? Fixed income theory and math say that the long-term bond price will increase more than the short-term bond, so the answer is to buy a long-term bond.
The other face in this strategy is the liquidity risk and credit risk of long-term bonds that could also affect the bond price. There is a high positive correlation between low interest rates and good economy expectations, so liquidity risk and credit risk premiums are also expected to shorten. Long-term bond prices increase even more.
In case I were a short-term investor, I would buy a long-term bond (10 years for example) rather than a short-term one and catch a capital gain. However my risk is higher, am I prepared to face that risk? That’s the question I must answer first.
okay, when interest rate are expected to decline, we should have a long duration bond, so that we get greater price increase.
When economic is getting worse, I switch topics - may be time for some equity valuation?