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Barbell bond strategies explained: Benefits from longer tenors

Phalguni Soni

Why barbell bond portfolios can outperform when rates rise (Part 3 of 10)

(Continued from Part 2)

Benefiting from higher yields at the long end

There’s an obvious benefit to investing in long-term tenors. Long-term (IEF)(VCLT) maturities typically yield more than shorter-term (SHY) maturities. Investors demand higher compensation as maturities increase. Reinvestment risk is lower, as it’s limited to the coupons you earn on the debt, as opposed to the principal and coupon. You can lock in the higher yields for a longer period by investing in long-term debt.

Long-term yields show a lower correlation with changes in the federal funds rate

Long-term maturities seldom move in lockstep with changes in the federal funds rate. Long-term bond yields are influenced by other macroeconomic factors, including economic growth and inflation expectations, besides base rate changes. In contrast, short-term tenors more highly correlate with changes in the federal funds rate and are prone to echoing them.

ETFs like the iShares 20+ Year Treasury Bond ETF (TLT), the Vanguard Long-Term Corporate Bond Index Fund (VCLT), and the ProShares Ultra 7-10 Year Treasury ETF (UST) provide exposure to long-term debt.

Long-term bonds and interest rate risk

But there’s also a higher-risk element involved in long-term debt, as the timeframe and durations are longer. The interest rate risk is higher. Long-term bond prices fluctuate more in response to changes in interest rates compared to short-term bond prices. That’s part of the reason why they yield more.

You can avoid this risk through a buy-and-hold approach. In that case, changes to the bonds’ market values due to changes in interest rates won’t affect returns since you’ll still receive the stated amount at maturity—unless the borrower defaults.

Continue to Part 4

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