What is barbell strategy

Should credit markets sell off, investors can sell their outperforming US Treasuries and other highly liquid quality assets and rebalance toward higher-risk assets at more attractive prices. When it comes to the credit side of the barbell, flat curves make higher-quality, intermediate maturity bonds more attractive than longer ones because they deliver more yield per unit of duration, with the sweet spot somewhere between three and five years.

You can reduce volatility without giving up too much return. We call this a risk-weighted barbell because credit is typically twice as volatile as interest-rate-sensitive assets, so investors would have to hold more rate exposure to even out the risk weighting on each side.

But as Display 1 shows, both would have had better returns per unit of risk than either US Treasuries or high yield. As of September 30, Historical analysis does not guarantee future results.

The data points represent 20 years annualized. Within credit for example, blending exposure to high-yield bond sectors with positions in select emerging-market debt and US commercial mortgage-backed securities and other securitized assets offers a good mix of credits that can generate high levels of income.

In fact, these sectors are among those that offer a better combination of yield and quality than traditional high-yield bonds Display 2 , underscoring the importance of taking a global, multi-sector approach to return-seeking assets. Through September 30, Past performance and historical and current analysis do not guarantee future results.

After a decade of expansion, financial markets may finally be approaching a turning point. For bond investors, that means finding a way to keep the income flowing while also shielding your portfolio from the full effect of higher volatility and slower growth. The traditional notion of the barbell strategy calls for investors to hold very safe fixed-income investments.

However, the allocation can be mixed between risky and low-risk assets. Adjustments to the ratio on each end can shift as market conditions require. The barbell strategy can be structured using stock portfolios with half the portfolio anchored in bonds and the other half in stocks.

The strategy could also be structured to include less risky stocks such as large, stable companies while the other half of the barbell might be in riskier stocks such as emerging market equities. The barbell strategy attempts to get the best of both worlds by allowing investors to invest in short-term bonds taking advantage of current rates while also holding long-term bonds that pay high yields.

If interest rates rise, the bond investor will have less interest rate risk since the short-term bonds will be rolled over or reinvested into new short-term bonds at the higher rates. Any long-term bonds held in the investor's portfolio remain untouched until maturity. As a result, a barbell investment strategy is an active form of portfolio management , as it requires frequent monitoring. Short-term bonds must be continuously rolled over into other short-term instruments as they mature.

The barbell strategy also offers diversification and reduces risk while retaining the potential to obtain higher returns. If rates rise, the investor will have the opportunity to reinvest the proceeds of the shorter-term bonds at the higher rates. Short-term securities also provide liquidity for the investor and flexibility to deal with emergencies since they mature frequently.

The barbell investment strategy still has some interest rate risk even though the investor is holding long-term bonds with higher yields than the shorter maturities.

If those long-term bonds were purchased when yields were low, and rates rise afterward, the investor is stuck with 10 to year bonds at yields much lower than the market. The investor must hope that the bond yields will be comparable to the market over the long term.

Alternatively, they may realize the loss , sell the lower-yielding bond, and buy a replacement paying the higher yield. Also, since the barbell strategy does not invest in medium-term bonds with intermediate maturities of five to 10 years, investors might miss out if rates are higher for those maturities.

For example, investors would be holding two-year and year bonds while the five-year or seven-year bonds might be paying higher yields. All bonds have inflationary risks. Inflation is an economic concept that measures the rate at which the price level of a basket of standard goods and services increases over a specific period. While it is possible to find variable-rate bonds, for the most part, they are fixed-rate securities.

Fixed-rate bonds might not keep up with inflation. Finally, investors also face reinvestment risk which happens when market interest rates are below what they were earning on their debt holdings. Assume that market sentiment has become increasingly positive in the short term and it is likely the market is at the beginning of a broad rally.

The investments at the aggressive—equity—end of the barbell perform well. As the rally proceeds and the market risk rises, the investor can realize their gains and trim exposure to the high-risk side of the barbell. Portfolio Management. 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.

The short-term side of the barbell would then be referred to as being "heavier," because it has more investments. 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. The potential benefits of investing using a barbell strategy are:. 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.

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. This approach purposely excludes middle-of-the-road bonds, which are those with intermediate terms.

Intermediate-term bonds have historically offered higher returns than 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.