Barbell Bond Portfolio
What is a Barbell Strategy?
The “barbell” strategy is a portfolio management approach that is popular with fixed income investors. It involves combining short-term (three months to three years) and long-term (seven to ten or more years) bonds, the portfolio weightings of which can be adjusted, while avoiding exposure to medium-term maturities. The below chart visualises the potential investment universe for this strategy.
The strategy is more tactical compared to other bond approaches as cash received from matured short-term holdings needs to be frequently reinvested, where the longer-term holdings aim to compensate investors for the higher interest rate risk (long-term bond prices are more sensitive to interest rate changes).
Key Learning Points
- A barbell portfolio is constructed of a number of bond holdings that sit at the two ends of the maturity spectrum, short and long-term, while exposure to medium-term maturities is avoided
- The short-term part of the portfolio provides flexibility, and should interest rates rise, they can capture the increase more quickly
- The long-term portion of the barbell portfolio allows for the higher yields to be locked in if interest rates go down
- The biggest challenge for barbell strategies is when the spread between the short and long duration bonds widens (i.e. the yield curve “steepens”)
Why Use a Barbell Strategy?
While the ultimate objective of a barbell strategy is to provide both stability and higher returns, the approach offers several benefits that investors can leverage:
- Higher liquidity and the opportunity to reinvest the proceeds of matured short-term bonds at a more attractive rate (should interest rates rise).
- The short-term portion of a barbell portfolio also offer greater flexibility and allows quick adjustments to the strategy if required.
- Combining together short and long-term bonds ensures higher level of diversification.
- In a flattening yield curve environment (i.e. the reduction of the yield spread between longer-term and shorter-term bonds), barbell portfolios are expected to outperform regardless of any yield curve shifts.
- Income investors may benefit from the longer end of the portfolio as long-term bonds provide higher yields than short-term bonds.
Barbell Bond Strategy Example
Constructing a barbell bond portfolio requires strong expertise and careful consideration of both the current market environment and the specific investment opportunities. Therefore, for this example we look at combining two ETFs: the Wisdom Tree’s Floating Rate Treasury Fund (USFR) for the short-term part and the Yield Enhanced U.S. Aggregate Bond Fund (AGGY) for the longer-term counterweight, both with a 50% weighting in the portfolio. This allocation would provide a yield to worst (an estimate of the lowest possible yield, assuming the issuer doesn’t default) of 4.78%, with a duration (a measure of the bond’s sensitivity to interest rate changes) of 3.31. The yield advantage of this theoretical portfolio would be 0.28% against the benchmark, but with roughly half of the duration risk, meaning that investors can reduce volatility without giving up too much return.
Asset Allocation with the Barbell Strategy
Applied within a broader context the barbell approach can also be structured as a mix of low and higher risk assets such as bonds and equities (unlike the traditional fixed income concept that we explore in this blog). The weightings of those assets can also be adjusted, and it is not necessary for them to be equal (it typically depends on the prevailing market conditions). Another example of a barbell is combining established large cap stocks such as those in the S&P 500 index with small and cap businesses that are featured in the Russell 2000 index.
What is Taleb’s Barbell Strategy for Managing Risk?
Nassim Taleb’s barbell strategy is a risk management approach aimed at protecting against “black swan” events (defined as extreme and unpredictable) while at the same time maintaining the upside potential. Taleb’s barbell portfolio is split in two halves – one consisting of very low risk investments such as cash equivalents or short-term government bonds and very high risk (and potential return) assets such as venture capital. While former is expected to provide capital protection during periods of elevated market volatility, the latter should be the growth engine of the portfolio. In theory, this should allow significant upside in favourable markets and limit risk should the opposite happen.
Barbell Strategy Risks
Although the barbell approach can provide stability and higher returns, it is highly sensitive to periods when the yield curve is steepening. This implies that the long-term bond yields are going up much quicker than those of the short-term bonds. In this scenario, the value of the bonds that form longer duration part of the portfolio would decline, while proceeds of the matured short-term holdings would still be reinvested into lower-yielding short-term bonds. We provide examples for such periods further below.
Bullet vs. Barbell Strategy
The “bullet” strategy is another approach to fixed income portfolio management, the returns of which are often compared to those of a barbell portfolio. However, the fundamental difference between the two strategies is that the bullet doesn’t hold bonds with multiple maturity dates. Instead, it holds multiple bonds that all mature around the same time with the aim of generating a large cash sum.
Generally, there are two case scenarios in which either of the strategies should outperform. They depend on the investors’ expectations about the shape of the yield curve:
- If the yield curve steepens (i.e. the spread between short and long-term bonds is widening, for example when investors expect higher interest rates in the future) a bullet strategy is expected to outperform.
- In the case of the yield curve flattening (where the spread between short and long-term bonds narrows) the barbell approach would outperform.
Therefore, the relative performance of both strategies would depend on how the yield curve changes. The chart below shows the 1-year rolling return of a hypothetical barbell strategy (with evenly allocated short and long-term bonds) against a bullet strategy. An indication of the barbell approach outperforming is when the dark blue line is above 0 and the shaded areas show yield curve inversion (spread calculated as the 10-year less the 2-year US Treasury yield).
Overall, each strategy outperformed at different times – the bullet outperformed immediately after inversions where the barbell did so during inversions, and 2-3 years after the yield curve flattened.
Conclusion
The barbell strategy is an actively managed approach that combines bonds from the two ends of the maturity spectrum (short and long-term). It is one of the key strategies in fixed income portfolio management, along with the bullet and ladder approaches, and is expected to outperform during a flattening yield curve environment.