Bond Investing Strategies

Bond Ladders, barbells, and bullets are strategies that will help the investor balance their bond portfolios to achieve their desired result. The terminology of these strategies actually reflects the character of that strategy. For example, a bond ladder will enable the bond investor to set up a bond re-investment strategy, in steps. The barbell approach resembles a barbell in that bonds are purchased heavily in the short end and the long end. Medium term notes are left out of the mix. Finally, with the bullet strategy, each bond will share the same maturity date. They will typically start at different intervals, but they all will mature together.

Let's review each of these concepts in more detail:

What does Bond Laddering mean?

Bond laddering simply refers to the diversification of a bond portfolio through purchasing a series of bonds that have increasingly longer terms to maturity. Bond laddering is similar to dollar cost averaging in the stock market. Let's consider a simple ladder. Lets assume the investor wants to keep their average bond term to 3 years and therefore purchases 1, 3, and 5 year treasury bonds. This ladder would have a weighted average maturity of 3 years (1 + 3 + 5) / 3 = 3. Let's take a look at an example chart for more detail:

By allowing you to keep the average weighted maturity of your bond portfolio down, bond laddering is especially helpful in managing interest rate risks associated with longer term maturities. A bond ladder allows investors to take advantage of interest rate environments that are trending higher. The liquidity created within your bond portfolio when a security matures allows for the reinvestment at higher interest rates and if interest rates are not higher, you will continue to have a majority of your portfolio in higher yields than the market.

Additionally, bond ladders enable the investor to choose an appropriate ladder for their specific situation. For example, an investor looking for longer term income (savings for college tuition or retirement income) will shift their average weighted maturity higher than a shorter term investor would.

Bond Bullets

The bullet strategy, also known as maturity matching, is ideal for investors who do not need to recover their principal until a specific date in the future. For example, some of us know that our children will begin college in 10 years. Using that as a guide, a bullet strategy would buy bonds that mature on a specific date and leave the money untouched until that time, thereby eliminating any interest rate risks. If you believe that there is a chance that you may need to redeem the bonds before they mature, you will want to stagger the purchase of your bonds, which will help minimize the interest rate risk associated with bond prices.

Bond Barbells

This strategy is the most aggressive out of the three that we discussed in this article. Remember, that the longer the term to maturity, the more risk in the price of a bond. The barbell portfolio buys short term bonds maturing in two years or less and long term bonds, maturing in 20 to 30 years. In effect, a barbell creates a medium term average weighted maturity. Traders that buy this strategy are anticipating that longer term yields will drop and that bond prices will skyrocket higher. They will then plan to sell their bonds and realize their gains. This strategy can backfire and put you in some real trouble as well. In situations where the yield curve steepens to the upside, short term yields drop while longer term yields gain strongly. In this scenario, you effectively are losing in both types of maturities.

Tim Ord
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