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Use caution when investing with a barbell fixed income strategy

Phalguni Soni

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

(Continued from Part 9)

Risks inherent in barbell strategies

You’ve read about the benefits of using a barbell strategy when rates are rising in the previous parts of this series. You’ve also read about how these benefits are likely to outperform other strategies when the yield curve flattens. In this part, you’ll read about some of the issues that you should consider while using a barbell strategy.

Reinvestment risk

As we mentioned earlier, a key element of the strategy involves re-investment of maturing short-term (SHY) securities. The strategy works fine if rates move up as anticipated. But if rates fall instead of increasing, you must be prepared to accept a lower yield on the re-invested principal.

But this scenario also has a positive—a rather large one. If rates fall across the yield curve, they’ll benefit your portfolio at the long end (TLT) of the barbell. You’ll find that the principal appreciation from falling rates at the long end (IEF)(VCLT) may make up for a large part of the shortfall in yields at the short end (SJNK). The exact impact on your portfolio would depend on the maturity split between long- and short-term debt and the shift in the yield curve.

Active management can increase transaction costs

Reinvesting periodically maturing short-term maturing debt can also increase your transaction costs compared to investing in a passive fixed income ETF. Investing in short- and long-term bond ETFs can help reduce transaction costs.

Steepening yield curve

The real risk to the strategy would come if the yield curve steepens. A steepening yield curve implies that the difference between long-term and short-term rates increases. This can hit the investor at both the long and the short end. Falling or lower short-term yields imply reinvestment of principal at lower yields. Higher long-term yields reduce the market value of your long-term securities. A bond bullet portfolio would likely outperform the barbell in this scenario. A yield curve typically steepens when markets are pricing in higher future inflation or economic growth.

For more bond market trends and analysis, please visit Market Realist’s Fixed Income page.

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