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Barbell Strategy: Balancing Offense and Defense with Your Bond Portfolio

Investing in Canadian and U.S. investment grade bonds (both government and corporate) over the past thirty years has essentially been, with some periods of interruption, a unidirectional trade, with yields steadily marching from the high teens (low twenties in some cases) to the low single digits. Looking in the rearview mirror, that inexorable decline has made investing in bonds and bond indexes a relatively straightforward proposition - and has made two yield curve investment strategies very popular - long duration bullet strategies and ladder strategies. However, as students of bond investing will tell you, there are three essential yield curve strategies: (1) bullet; (2) ladder; (3) barbell. We haven't seen a lot written about barbell bond investing over the past thirty years. Why is that, and furthermore, what is a barbell investment strategy? A barbell bond investment strategy is implemented as it is named - with 50% weighting at the short end of the yield curve and a 50% weighting at the long end, with nothing in the middle.

In effect, it barbells your bond holdings, balancing "defensive" holdings in the short "bucket" with "offensive" holdings in the long "bucket". The 50% in the very short duration instruments - floaters and fixed rate bonds with near maturities, provide very little duration (interest rate) risk, and provide a hefty amount of capital to benefit from rising short term interest rates. That very defensive positioning preserves capital and allows an investor to benefit from rising short term yields. The 50% invested in the longer duration instruments provides higher income investors need in a low rate environment, as well as exposure to the longer end of the yield curve in the event that long term rates actually decline.

Why invest with a barbell as opposed to a bullet strategy, or a laddered strategy? It's that combination of a balanced defense-offense that makes it attractive, particularly through a period where interest rates rise as opposed to decline, but you aren't certain when the rising action will actually occur! Simply stated, the barbell portfolio will, if you assume it has similar duration to the bullet or the ladder, provide comparable levels of current income, but will have greater convexity, and thus will outperform those strategies in a rising rate environment. I am oversimplifying somewhat, because the amount that rates rise, and the shape of the yield curve affect the outcome. Convexity is used to measure the expected change in the price of a bond that is not explained by duration. Barbell portfolios, due to their greater convexity, are particularly well suited to environments where short term rates experience a material increase quickly, and where the yield curve flattens as opposed to steepens.

Thinking about your bond investments on a risk-adjusted basis, a barbell bond strategy provides either a good supplement to your existing laddered, bullet or broad indexed strategy, or if you are just now thinking of investing in the bond market, a good way to enter the market with new money. We all know that a winning team strategy in sports incorporates strong offense and defense. Your bond portfolio strategy should be no different. Interest rates have a mathematical floor, and there isn't much room before they get there. It doesn't make good sense to invest as if the floor doesn't exist. Conversely, predictions about the timing of rate increases have been wrong for the last several years, but that shouldn't mean that you ignore the prospect until it actually happens. Barbelling provides a balanced approach that tends to outperform in periods of rising rates. It's a smart risk adjusted way to invest in investment grade bonds.

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