In our earlier videos, we have discussed the different types of yield curves and the inverse relationship between bond prices and yields.

While the yield curve indicates the available bond yields across maturities, a key question remains should investors choose short-term or long-term bonds.

Let’s understand this through two scenarios.

When interest rates are expected to decline, investors may prefer to buy and hold longer tenure bonds offering higher interest rates. This may allow investors to earn higher interest rate income for a longer term as compared to holding a shorter maturity bond. On the other hand, when interest rates are expected to rise, investors may choose shorter maturity bonds to reinvest their capital at higher interest rate once the bond matures.

When interest rates are rising, Neha buys Bond A with a 1-year maturity at a 6 percent annual interest rate. After one year, she receives the interest and principal, which she now reinvests at a higher rate. Thus Neha invests in shorter maturity bonds when interest rates are rising.

When interest rates are falling, Neha buys Bond B with a 5-year maturity at a 7 percent annual interest rate. She effectively locks in this higher rate for the long term, anticipating that rates are expected to fall. Thus Neha invests in longer maturity bonds when interest rates are falling.

Understanding the direction of interest rates plays an important role in deciding whether to invest in short term or long term bonds. Investing in short term bonds in a rising interest rate scenario and investing in long term bonds in a declining interest rate scenario may help investors optimise the interest income from their bond investments.