Bonds: Bullet Strategy Definition
Reduce yield volatility and risk with a bond bullet strategy
A bullet strategy is one of three approaches to constructing a portfolio of individual bonds, the other two being the ladder and barbell strategies. All three strategies attempt to reduce yield volatility and risk, each in its own way. All three depend upon strategic reinvestment of the proceeds from matured bonds. While each inevitably poses a risk -- all investments do -- all three avoid one of the traps posed by bond funds, which is that the underlying strategy of most bond funds is a consistent everyday reinvestment of mature bonds (and often the sale of others before maturity). In effect, bond funds never offer the individual investor known maturity dates where even in the worst case, the investor at least gets back his principal. Like any other fund, a bond fund can lose the money you've invested.
Individual bond strategies, on the other hand, hold a finite number of bonds, each of which has a known maturity date. Consequently, in most cases even when the economic environment turns against bonds, you can hold your bonds to maturity and eventually get your return of principal.
Bond Bullet Strategy
An investor who uses a bullet strategy purchases several bonds that mature at the same time. By targeting this specific maturity, the investor aims to invest in a particular segment of the yield curve – thus the term “bullet.”
Although all of the bonds held in a bullet strategy portfolio bullet mature at the same time, they are all purchased at different times – like the other two strategies, ladder, and barbell, the bullet strategy reduces the impact of interest-rate fluctuations through diversification. For instance, an investor buys a 10-year bond in a given year, and then makes the next purchase three years later (this time, a bond scheduled to mature in seven years). If rates rise in the intervening time, the investor will earn a higher rate than if he or she invested the entire portfolio in the first year.
Naturally, rates could also fall during that two-year period, meaning that the investor would earn a lower rate and would have been better off with a different approach. However, the primary goal of staggering the purchases is to “hedge,” or protect, against the possibility rates could rise sharply during the interval in which the bullet strategy is in effect. As a strategy, it's not exceptional at offense -- it won't necessarily beat buying a single bond -- but it's great defense and both assures the return of principal and protects you to a degree from interest rate risk.
Another example: an investor knows his or her daughter will be heading to college in 2024. Her father, wanting to keep the principal safe, chooses to invest in bonds rather than stocks and elects to use a bullet strategy. In this scenario, the father invests at five different times: in 2014, 2016, 2018, 2020, and 2022, each time buying one or more bonds that mature in 2024. Two benefits:
- The student's father doesn't have to come up with all the funds at the same time in order to put the bullet strategy to work. The bond purchases occur over a six-year time span.
- Because the maturity dates are known and, in fact, selected to coincide with his daughter's needs for college tuition, the father gets the principal back when he needs it, still keeping it safe as the bullet strategy unfolds to the bonds' maturity.
Investors who know they will need the money at a particular time (as in the college tuition example or for retirement) and who don't need the money until that time often use the bullet strategy.
Keep in mind, however, that a bullet strategy provides no protection against credit risk. As always, the risk of investing in lower grade corporate bonds may increase your return, but also your risk of default.