The Bond Barbell Variation On The Bond Ladder Strategy For A Rising Interest Rate Environment

2012 December 10
by Kyle Bumpus
from → Investing And Investments

The bond barbell strategy is a variation on the bond ladder strategy particularly well-suited for rising interest rate environment. The most common complaint leveled against bond funds, especially long-term bond funds, is that the loss of principal experienced by these funds during periods of rising interest rates is too high for investors without very long time horizons. An argument can be made that so long as your time horizon is greater than your fund’s effective duration, those coupon payments reinvested at higher yields as rates rise will be a long-term benefit, but many investors just don’t like to lose money, not even in the short-term. Thankfully, there’s a middle road, a way to maximize your long-term average coupon without suffering too much principal volatility.

It should be noted that I use bond mutual funds instead of any kind of bond ladder for my long-term investment portfolio; however, I have used variations on the bond/cd ladder strategy in the past for shorter-term goals.

The Bond Barbell Strategy

Unlike a traditional bond ladder where bonds of different maturities are bought more or less sequentially from top to bottom, a bond barbell consists of a portfolio of long-term bonds (to drive yield) and very short-term bonds (to maintain a reasonable amount of liquidity) without any intermediate maturity bonds. For example, you may invest half or two thirds of your bond barbell in 20 year treasury bonds with the remaining one third or one half in 1 year treasury bonds (with perhaps some 90 day T-Bills thrown in).

 Advantages Of A Bond Barbell

  • Quick turnover of assets – While not all of your bond portfolio will mature in any given year, enough will to maintain financial flexibility. If rates are rising, you can reinvest some of those maturing bonds at increasingly higher rates while still precisely controlling the overall duration and maturity date of your bond portfolio. You can’t really do this with bond funds, which makes them less suitable for shorter-term investment goals.
  • More flexible than a traditional bond ladder – There’s more room to time the market with a bond barbell because while long-term bonds are sensitive to interest rates, short-term bonds aren’t, relatively speaking. You’ll have a constant stream of maturing bonds to reinvest as you see fit, either back into short-term bonds, into long-term bonds, or a split between of the two.
  • Higher increase in value, on average – On average, a bond barbell strategy will lead to slightly higher investment outcomes than either a traditional ladder or a non-laddered approach in a rising rate environment. More cash is good.

And The Disadvantages…

  • By definition, you’re compromising – If rates do rise, you’ll still likely be worse off with a bond barbell than with short-term bonds or cash investments. It’s a trade-off.
  • Doesn’t work so well with an inverted yield curve – Whereas traditional bond ladders and bond funds still do just fine when the yield curve is inverted since they tend to own bonds of varying durations, bond barbells yield poor risk-adjusted returns in that scenario.

 

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