What is Barbell Strategy?
Definition: Barbell strategy is defined as a fixed-income portfolio strategy in which investors invest in long- and short-duration bonds, but they do not invest in intermediate-term bonds. The exact opposite of this strategy is the bullet strategy that suggests investing only in intermediate-term bonds.
Barbell strategy is an investment strategy that states that the best way to have a balance between risk and reward is to invest in two extreme policies that have high risk and no risk like long- and short-duration bonds and not to invest in the middle-of-the-road choice of investment like intermediate-duration bonds. Every investor seeks to maximize the returns from their investment. Therefore, the investors who follow this strategy invest in two extreme policies.
Understanding Barbell Investment Strategy
Barbell investing helps investors make a portfolio that can provide the best returns to the investor. The structuring and deciding of any portfolio start with identifying the degree of risk that an investor can tolerate and the risk involved in investment.
Every investor has a different potential to bear the risk of investment. For instance, a young professional may take high risk while a retired person may want to have a steady income which means low risk. Therefore, the barbell strategy helps these investors to have a portfolio that can satisfy their risk-bearing capacity.
The investors who follow this strategy purchase short-term and long-term bonds. This helps the investors to have a low risk while still having higher-yield and long-term bonds in their portfolios. This strategy needs active management as this strategy includes short-term bonds. When short-term bonds reach maturity, an investor must purchase new short-term bonds and replace them. The same happens with long-term bonds, where the investor has to purchase new long-term bonds after the maturity of previous long-term bonds.
Therefore, active participation is necessary for the barbell strategy. With low participation, the investor will have only long-term bonds that may not yield the desired interest rate.
Reasons Why Investors Use Barbell Investing Strategy
Barbell strategy is one of the advantageous investment strategies that help an investor to lower their risk while having access to higher yield bonds. The advantages of using this strategy include:
1. Access to long-term high-yield bonds
With the help of the barbell strategy, the investors who do not want to take high risk can get access to long-term high-yield bonds, getting it combined with short-term bonds.
2. Reduces the risk
This strategy decreases the risk of investing. It is so because the short-term and long-term bond returns are negatively correlated. This means that when short-term bonds work well in the market, then the long-term bonds may struggle and vice-versa.
The barbell strategy can be used in terms of bonds or equities. If an investor wants to hold a mix of equities and bonds, the combination can be customized.
Risks Associated with Barbell Investing Strategy
1. Long-term bonds Interest rate
Although the barbell strategy lowers the risk of investment, this strategy still has some interest rate risk. As per this strategy, the investor is holding long-term bonds with higher yields than short-term bonds, but the risk is still associated with the return of the long-term bond. If these long-term bonds are purchased at low yields but if the rate rises afterward, the investor will face a situation where he will get completely stuck with the 10 to 30 years bonds that will yield him less interest than the market. If he decides to sell these low-yielding bonds in the market, he may even bear losses for buying the higher-yield bonds.
2. Medium-term bond may give more interest
Another risk related to interest is that the barbell strategy ignores the medium-term bonds, which may yield an interest higher than the long-term or short-term bonds. In other words, it may be possible that a five-year or seven-year bond can give more interest rate than the bonds having a maturity of two or ten years which an investor may be holding.
3. Inflation Risk
Inflation measures the rate at which the price level of standard goods and services increases over some time. However, it is possible to find variable-rate bonds, but some bonds are of fixed-rate. The fixed-rate bonds are more prone to get affected by inflation. If an investor holds a fixed-rate bond having a pay of 2%, but the inflation increases by 3%, then the investor will have to bear a net loss of 1% due to the inflation.
4. Reinvestment Risk
The investors may face the risk of reinvestment. The reinvestment may happen when market interest rates are below what they are earning on their holdings. For instance, if an investor receives a 3% interest rate on the bonds that matured and returned thee, principal. But the market rate has fallen to 2 %. In this case, it is difficult for an investor to find security that can yield an interest higher than 3%. Therefore, the investor has to go the risker and low credit-worthy bonds then.
Advantage of the Barbell Strategy
The potential advantages associated with the Barbell strategy are:
- It enables the investors to have long-term approach bonds that have a higher yield.
- Barbell’s strategy provides a greater variety than a bullet strategy as it allows the purchase of multiple bonds that are supposed to mature at the same time.
- It is less risky in the sense that the falling rate will prompt the investors to reinvest at lower rates at the time their bonds mature.
- The short-term bonds frequently mature; hence it provides the investors an opportunity with liquidity and flexibility at times of emergencies.
Application of Barbell Investment Strategy
Barbell strategy is usually applied in three types of portfolios fixed income, equity, and wealth portfolio.
1. Fixed Income
When the barbell strategy is applied on the fixed income portfolios, the investor pair short-term bonds with long-term bonds, the investor’s success depends majorly on the interest rate.
The barbell strategy requires more scrutiny in terms of investing in equity. The investor is investing in two groups of stocks. One group of stocks is classified as safe, and the other is classified as risky. Safe stocks are stocks with a long history of dividend payments. And risky stocks are the technology stocks.
Wealth portfolio includes safe investment, alternative investment, and index funds. The barbell strategy is more flexible when applied to the wealth portfolio due to its scope.
Investment options for Credit Union using Barbell Strategy
1. Short-term (for the period of 3 years or less)
- Mortgage-backed securities are having an average life of three years or less.
- Certificate of Deposit
- Treasuries and so on
2. Long-term (for the period > 3 years to 10 years)
- Commercial mortgage-backed securities
- Collateralized mortgage obligation
- Mortgage-backed securities are having an average life of 10 years or less.
- Investment-grade corporate bonds
- Taxable bonds
- Tax-free municipal bonds and so on
When Should Credit Union Implement Barbell Investing Strategy?
For credit unions, the best time for them to implement the barbell strategy is when there is a wide gap between short-term and long-term bond yield.
The long-term bonds yield will show a rise along with the subsequent fall in the prices at a much faster rate than the short-term bonds yields. When the long-term bonds show a decline in value, the investor can reinvest on the low-yielding bonds.
An investor will not face any negative consequences even if they hold longer-duration bonds to maturity.
According to the barbell strategy, it supports the paring of two entirely different types of assets. One that is safe for investment, guaranteeing a decent rate of return, and the other, although highly profitable, falls under the risky category.
Much of the interest rate depends on the viewpoint of the investor. An investor has to weigh the market risk at the time of implementing the barbell strategy.
One of the reasons that this strategy has garnered noticeable attention from the investors is because the barbell strategy demands frequent attention and is labor-intensive. Investing in several bonds that have a maturity in the same year will allow the investors to invest passively.
How effective do you find barbell investment strategy in offering better returns on investments? Share your opinion with us in the comment section below.