What is the barbell strategy
The barbell strategy is when investors purchase short term and long term bonds but not intermediate-term bonds. This particular distribution on two extreme ends of the maturity timeline creates a barbell shape. This strategy exposes investors to high yielding bonds with limited risk.
Quick Summary Points
- The barbell strategy is a fixed income strategy where the investor only buys short or long bonds.
- This strategy helps decrease downside risk while still having exposure to higher yield long term bonds.
- A flattening yield curve environment is best suited for this strategy while a steepening curve is detrimental.
Why use a barbell strategy?
This 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. This strategy also includes long term bonds, which have maturities of 10 years or longer. These bonds have higher yields to compensate for higher interest rate risk.
The first advantage of the strategy is that it allows investors to have access to higher yield bonds which are long term bonds. The second advantage is that it decreases risk. The strategy lower 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. As interest rates increases, the short term bonds will roll over and be reinvested at a higher interest rate environment. The reinvestment will offset the decrease in the value of longer-term bonds. On the other hand, as interest rate decreases, the value of the longer-term bonds will increase.
An active form of portfolio management
This strategy requires active management. This is because as short term bonds reach their maturity, new short term bonds must replace it. The same goes for long term bonds. As maturity dates approach, an investor must buy new long term bonds. This 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 has 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 losses value as interest rates increase.
Another risk or tradeoff of the barbell strategy is that the investor has no 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 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 long term bond. Usually, a normal yield curve slopes up and plateaus. This 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 an opposite. This is when yields on long term bonds are increasing faster than short term bonds. When this occurs, the value of long term bonds decreases faster. In a barbell strategy, investors might have to invest proceed into the 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 that have a fast-growing yield.
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