A portfolio with only short-term and long-term bonds
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The barbell strategy involves investors purchasing short-term and long-term bonds, but not intermediate-term bonds. The particular distribution on the two extreme ends of the maturity timeline creates a barbell shape. The strategy offers investors exposure to high yielding bonds with limited risk.
The barbell strategy is a fixed income strategy where the investor only buys short-term and long-term bonds.
The strategy helps decrease downside risk while still having exposure to higher-yield, long-term bonds.
A flattening yield curve environment is best suited for the barbell strategy, while a steepening curve is detrimental to the strategy.
Why Use a Barbell Strategy?
Thie barbell strategy lower risks for investors while providing exposure to higher yield bonds. Short-term bonds have a maturity rate of fewer than five years. They are relatively safer than long-term bonds due to less exposure to interest rate risk. The strategy also includes buying long-term bonds, which have maturities of 10 years or longer. The bonds offer higher yields to compensate for higher interest rate risk.
The first advantage of the strategy is that it enables investors to have access to higher yield long-term bonds. The second advantage is that it decreases risk. The strategy lowers risk as short-term and long-term bonds’ returns tend to be negatively correlated. So, when short-term bonds do well, the long-term bonds tend to struggle and vice versa. Thus, by holding bonds with different maturities, investors have less downside risk.
The reason the returns are negatively correlated is because of interest rates. If interest rates increase, the short-term bonds will be rolled over and reinvested at a higher interest rate. The reinvestment will offset the decrease in the value of longer-term bonds. On the other hand, if interest rates decrease, the value of the longer-term bonds will increase.
An Active Form of Portfolio Management
The barbell strategy requires active management. It is because as short-term bonds reach their maturity, new short-term bonds must be purchased to replace them. The same goes for long-term bonds. As maturity dates approach, an investor must buy new long-term bonds. It helps maintain the barbell strategy. Without active management of the strategy, the investor will end up with only long-term bonds that are susceptible to interest rate risk.
What are the Risks?
Interest rate risk is still a concern even though the investor owns both long-term and short-term bonds. If long term bonds are purchased when interest rates are relatively low, they might end up with bonds that quickly lose value as interest rates increase.
Another risk or tradeoff of the barbell strategy is that the investor lacks exposure to intermediate-term bonds. Historically, intermediate-term bonds offer better returns than short-term bonds. Additionally, they are only slightly riskier. Compared to long term bonds, the return is only slightly lower. By excluding intermediate-term bonds, investors might be losing out on additional returns.
When is the Best Time for the Barbell Strategy?
The best time for using the barbell strategy is when the yield curve is flattening. A flat yield curve means that there is little difference between the yield of a short-term bond and a long-term bond. Usually, a normal yield curve slopes up and plateaus. It is because investors need to be compensated with the higher yield for taking on the additional risk of long-term bonds. In a flattening yield curve, the spread between a short-term and long-term bond shrinks.
Another way to think of a flattening yield curve is that yields on short term bonds rise faster than that of long term bonds. On the other hand, a steepening yield curve is the opposite. This is when yields on long-term bonds are increasing faster than short-term bonds. When it occurs, the value of long term bonds decreases faster. In a barbell strategy, investors might need to invest in lower-yield, short-term bonds to balance the portfolio.
In a flat yield curve, investors can reinvest proceeds from maturing short-term bonds into new bonds with a faster-growing yield.
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