Barbell Strategy and Bonds
Investing with a barbell strategy offers you a way to gain exposure to a particular bond maturity length without having to invest your entire portfolio in the same segment of the market. For instance, an investor who wants exposure to the ten-year maturity segment could invest all of his cash in ten-year bonds (an approach called a “bullet strategy.”)
However, to diversify risk, the investor could invest half of his or her portfolio in bonds with five-year maturities and the other half in bonds with 15-year maturities to achieve an average maturity of ten years. The barbell strategy is so-named because the portfolio is heavily weighted on two sides, just like a barbell.
A bond barbell doesn’t necessarily need to have an equal weight on both sides–it can be tilted in one direction or another based on an investor's outlook and yield requirements.
Securities Turnover Within the Barbell
A bond barbell is an active strategy that requires monitoring since the short-term securities will need to be rolled into new issues on a frequent basis. Also, most investors approach the longer-term side of the barbell by buying new securities to replace the existing issues as their maturities shorten. Naturally, the current yield of the new securities, as well as the size of the gain or loss the investor has in the existing bonds, will play a role in these decisions.
Benefits of the Barbell
The potential benefits of investing using a barbell strategy are:
- Greater diversification than a bullet strategy that has all assets of the same maturity
- The potential to achieve higher yields than would be possible through a bulleted approach
- Less risk that falling rates will force the investor to reinvest their funds at lower rates when their bonds mature
- If rates rise, the investor will have the opportunity to reinvest the proceeds of the shorter-term securities at the higher rate
- The fact that the short-term bonds mature frequently provides the investor with the liquidity and flexibility to deal with emergencies.
What Are the Risks?
The primary risk of this approach lies in the longer-term end of the barbell. Long-term bonds tend to be much more volatile than their short-term counterparts, so there is the potential for capital losses if rates rise (as prices fall) and the investor elects to sell the bonds prior to their maturity. If the investor has the ability to hold the bonds until they mature, the intervening fluctuations won’t have a negative impact.
The worst-case scenario for the barbell is a “steepening yield curve.” This phrase may sound very technical, but it simply means that long-term bond yields are rising (and prices falling) much faster than the yields on short-term bonds. In this situation, the bonds that make up the long end of the barbell decline in value, but the investor may still be forced to reinvest the proceeds of the shorter end into low-yielding bonds.
The opposite of the steepening yield curve is the flattening yield curve, where yields on shorter-term bond rise faster than the yields on their longer-term counterparts. This situation is much more favorable for the barbell strategy.
This approach purposely excludes middle-of-the-road bonds, meaning those with an intermediate term. Intermediate bonds have historically offered higher returns than 30-day T-bills with minimal additional risk, and only slightly lower returns than long-term bonds. Many conservative investors prefer to include some intermediate-term bonds in their portfolio, especially during certain economic cycles where intermediate-term bonds tend to outperform other bond maturities.