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 their 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 equal weight on both sides—it can be heavier on one end, based on an investor's outlook and yield requirements.

The Barbell Structure

The barbell strategy generally divides a portfolio into two sections, a low-risk side, and a high-risk side. The conservative side of the portfolio is filled with short-term bonds, while the higher risk side of the portfolio is full of long-term, higher risk bonds.

Long-term bonds carry more risk because they are more susceptible to rising inflation. Short-term bonds, which mature in five years or less, are less likely to be affected by inflation and are therefore considered less risky in a barbell strategy.

To build a barbell bond portfolio, an investor could split their investments into a 90/10 split, where 90% of their investments are short-term, and 10% are long-term. The short-term side of the barbell would then be referred to as being "heavier," because it has more investments.

Securities Turnover Within the Barbell

A bond barbell is an active strategy that requires monitoring and frequent action, since the short-term securities will need to be rolled into new issues on a frequent basis. 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—purchasing multiple bonds that mature at the same time.
• 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.
• Short-term bonds mature frequently, providing 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 (bond prices fall when rates rise) 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 are 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 short-term end into low-yielding bonds.

The opposite of the steepening yield curve is the flattening yield curve, where yields on shorter-term bonds rise more quickly than the yields on their longer-term counterparts. This situation is much more favorable for the barbell strategy.

A Drawback

This approach purposely excludes middle-of-the-road bonds, which are those with intermediate terms. Intermediate-term bonds have historically offered higher returns than 30-day Treasury bonds 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.

The drawback of a barbell strategy is that the investor misses the opportunity to use intermediate-term bonds in their portfolio, betting that returns over time will be higher without these mid-range bonds.