One common barbell strategy for fixed income investing is for investors to focus on short- and long-dated maturities and less on the intermediate term.
Barbell strategies are one way to lower so-called “duration risk”
The barbell approach typically works best when the yield curve is flattening
When stock investors think about allocation, it’s typically about overweighting and underweighting sectors and individual company shares.
But for fixed income investors, it’s often about duration risk. When it comes to fixed income strategies, most people think of laddering approaches, where investments are spread out equally across the yield curve. But that strategy won’t necessarily work if rates are fluctuating.
Instead, fixed income investors should consider taking a look at the barbell approach. With this strategy, buyers spread their risk by focusing on short-term and long-term maturities, ignoring the belly of the yield curve. This approach is called a barbell because holdings are bunched on either end, with few investments in the middle.
Here are a few reasons you might want to consider the barbell strategy.
The barbell strategy generally divides an investor’s fixed income portfolio into lower-risk and higher-risk holdings, with short-term bonds representing lower risk and longer-term bonds being higher risk. Because there are two sides of the portfolio, this strategy can be weighted numerous ways depending on the person’s needs.
For example, if you thought rates were going to rise quickly over a few years, you might allocating 75% of your fixed income portfolio to shorter maturities and 25% to longer maturities. This would give you more bonds to potentially reinvest at higher rates instead of waiting for bonds to mature in a traditional laddered portfolio.
A big reason some investors use the barbell strategy? They’re hoping the returns on their portfolio over time will be higher without the mid-range bonds.
Portfolio diversification and reducing risk are two potential barbell strategy benefits. For example, if you want exposure to the 10-year U.S. Treasury, you could simply buy a 10-year Treasury bond. That’s known as a bullet strategy. To replicate owning a 10-year bond with the barbell approach, you’d buy an equal amount of five-year and 15-year maturities that blend together to get an average maturity of 10 years.
This can reduce investment risk because short-term and long-term bonds tend to be negatively correlated. Sometimes short-term bonds perform better when long-term bonds underperform and vice versa.
Another potential benefit of pursuing the barbell strategy means an investor can reinvest the proceeds of the shorter-term securities, possibly at a higher rate, giving them a chance to receive higher yields than if they would’ve simply bought a 10-year bond. Additionally, if the investor needs liquidity, the short-term bonds will mature faster, giving them flexibility.
A flattening yield curve benefits the barbell strategy because the yields on short-term bonds are higher than long-term bonds, so investors may be able to get higher yields when their shorter-dated bonds mature.
There are a few downsides to the barbell strategy. First, investors miss the opportunity to use intermediate-term bonds in their portfolio. Sometimes these bonds in the belly of the yield curve offer higher returns than shorter-dated bonds without much additional risk, and they often have only slightly lower yields than longer-dated bonds.
Another risk of this strategy is in the longer-dated maturities. If you hold a bond until it matures—assuming the issuer doesn’t default—you’ll get your principal plus all promised interest. But if you need to sell before maturity, you run the risk of losing money if bond prices fall. Why would a bond fall in value? If interest rates rise, newly issued bonds are more enticing than the older, lower-yielding bonds, so those will become worth less.
So, the barbell strategy does poorly when the yield curve is steepening. Not only will investors lose money on their long-dated bonds because of falling prices, but their shorter-term bonds mature when yields on near-dated bonds are still low.
Barbell positions can be a short-term or long-term holding, depending on how the strategy is weighted. Much of it depends on the investor’s view of interest rates.
In a short-term strategy, an investor may invest 90% of their portfolio on the short end and only 10% on the long end, and then reinvest maturing bonds into longer-dated bonds. Conversely, if the investor expected rates to be stable or perhaps fall, they might buy more longer-dated bonds to lock in higher rates.
Like any other fixed income strategy, the barbell approach requires you to have a personal interest rate outlook. But it’s one way to potentially lower duration risk and aim for some portfolio diversification at the same time.
Investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk, and special tax liabilities. May be worth less than the original cost upon redemption.
Asset allocation and diversification do not eliminate the risk of experiencing investment losses.
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