Definition and Examples of the Bullet Bond Strategy
An investor who uses a bullet strategy purchases several bonds that mature at the same time. By targeting this specific maturity date, the investor aims to invest in a particular segment of the yield curve. That's where the term “bullet” comes from—it's an attempt to hit a specific point in the yield curve.
- Alternate name: Bullet bond portfolio
To implement a bullet bond strategy, you could buy one bond with a maturity date 15 years from today. In five years, you could buy one that matures in 10 years on the same date. Five years later, you buy a bond with a maturity of five years to expire on the same date. On that date, they all mature.
How Does the Bullet Bond Strategy Work?
The bullet bond strategy might be defined as defensive. Following this strategy doesn't necessarily mean you'll beat the returns of an investor who buys a single bond. Instead, you're trying to ensure the return of principal while protecting yourself (to a certain extent) from interest rate risk.
By purchasing bonds at different times, the bullet strategy leverages diversification to reduce the impact of interest-rate fluctuations. For instance, if you're following the bullet bond strategy, you might buy a 10-year bond in one year, and three years later buy a seven-year bond.
If rates rise between the first purchase and the second, you'll earn a higher rate than if you'd invested the entire portfolio in the first year. Rates could also fall during those three years, but the primary goal of staggering the purchases is to “hedge” or protect against the possibility that rates could rise sharply in a given year.
Planning for Future Expenses
The bullet bond strategy works exceptionally well if you're planning for an expense. For example, suppose you want your child to head to college in 2030. You want to keep the principal safe, so you choose to invest in bonds rather than stocks and decide to use a bullet strategy.
You land on a bullet strategy that includes five investments in five different years: 2020, 2022, 2024, 2026, and 2028. In each of these years, the bonds all share the same maturity date in 2030 and can be used to pay for tuition.
What It Means for Individual Investors
Consider these two benefits to the bullet bond strategy:
- You don't need to have all the cash you plan to invest right away. When you're preparing for your child to go to college, the purchases take place over eight years. That gives you plenty of time between purchases to save the cash for the next bond investment.
- Selecting a maturity date that coincides with a major expense (college, in this example) ensures that your family will have cash when they need it most.
As with all bond strategies, a bullet bond investor faces a certain level of credit risk. If you buy a bond from an entity that goes bankrupt, that entity could fail to honor the bond terms. This risk increases for those who invest in lower-grade corporate bonds. The tradeoff is that lower-grade bonds often offer higher interest rates.
Benefits Over Bond Funds
The bullet bond strategy shares similar concepts with other bond-investing strategies. Most strategies attempt to reduce yield volatility and risk, though each pursues this goal in its own way. All bond strategies depend upon the strategic reinvestment of the proceeds from matured bonds.
The downside to bond funds effectively removes the offer of a known maturity date—a date when the investor, at a minimum, gets back their principal. With a bond fund, you can lose the money you've invested.
- The bullet bond strategy is a bond-investment strategy in which bonds with the same maturity date are bought over a period of several years.
- The bullet bond strategy works best when you have a specific expense in the future that you'd like to prepare for, such as sending a child to college.
- The bond bullet strategy attempts to hedge the risk of inflation by purchasing bonds at different intervals.