Barbell strategy

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In finance, a barbell strategy is formed when a trader invests in long- and short-duration bonds, but does not invest in intermediate-duration bonds. This strategy is useful when interest rates are rising; as the short term maturities are rolled over they receive a higher interest rate, raising the value. [1] A contrasting strategy is the bullet strategy, which involves investing only in intermediate-term bonds.

Contents

Concept

A barbell strategy is one of several different types of portfolio strategies that is designed to create a reasonable return on the investments that are part of the asset portfolio. The barbell strategy is built around the concept of focusing on the maturities of the securities in the portfolio by making sure the maturity dates are either very close or at a distant date. It is similar to the laddered approach. [2]

Application

The key to employing a barbell strategy is seeking to include bonds and other securities set to mature either in the short term or the long term. While it is always a good idea to include a mix of investments with a variety of maturation dates, this approach concentrates those dates at opposite ends of the spectrum. This means that two blocks or groups are created within the portfolio, rather than having securities that mature consistently from one period to the next. [3]

Benefits

The barbell strategy [4] allows for a quick turnover of a significant amount of the assets in the portfolio at one time. For example, attention should be paid to the block of short-term investments, so they can all be rolled over into new short-term investments as they reach maturity. Typically, this leads to an increase in the value of the investments that are turned over, thus increasing the overall value of the investment portfolio. [5]

Theoretical results

Under simplistic assumptions about forward rates, a bar-bell portfolio comprising only the shortest dated bond and the longest on offer has been shown to maximize modified excess return. [6]

Variations

One variation of the barbell strategy involves investing 90% of one's assets in extremely safe instruments, such as treasury bills, with the remaining 10% being used to make diversified, speculative bets that have massive payoff potential. In other words, the strategy caps the maximum loss at 10%, while still providing exposure to huge upside. [7] This strategy works best during periods of high inflation for three reasons: High interest rates make put options cheaper in accordance to the Black Scholes option pricing formula, stock crashes have historically occurred during periods of high interest rates (1987, 1998, 2000, 2007, etc.), and a high interest rate helps finance the trader's bankroll for when the market doesn't crash, which is most of the time. With interest rates still at zero, this strategy is much less effective. Thirty-year bonds pay more, but are volatile. Foreign and corporate bonds are also quite volatile and far from risk-free. [7]

Related Research Articles

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<span class="mw-page-title-main">Bond (finance)</span> Instrument of indebtedness

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor. The timing and the amount of cash flow provided varies, depending on the economic value that is emphasized upon, thus giving rise to different types of bonds. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.

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In finance, a bullet strategy is followed by a trader investing in intermediate-duration bonds, but not in long- and short-duration bonds.

Fixed-Income Relative-Value Investing (FI-RV) is a hedge fund investment strategy made popular by the failed hedge fund Long-Term Capital Management. FI-RV Investors most commonly exploit interest-rate anomalies in the large, liquid markets of North America, Europe and the Pacific Rim. The financial instruments traded include government bonds, interest rate swaps and futures contracts.

Dedicated portfolio theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows. This is achieved by purchasing bonds and/or other fixed income securities that can and usually are held to maturity to generate this predictable stream from the coupon interest and/or the repayment of the face value of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.

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References

  1. ↑ Cohen, Marilyn. "The Barbell Strategy". Forbes.com. Retrieved 19 March 2012.
  2. ↑ Adams, Katie. "How do I use a barbell strategy?". Investopedia. Retrieved 19 March 2012.
  3. ↑ Smith, Jim. "The Barbell Investment Strategy". The College Investor. Retrieved 19 March 2012.
  4. ↑ Lawler, Jasper. "Is it time to drop the barbell investing strategy in 2021?". www.flowbank.com. Retrieved 2021-02-03.
  5. ↑ Cohen, Marilyn. "The Barbell Strategy". Forbes.com. Archived from the original on July 25, 2009. Retrieved 19 March 2012.
  6. ↑ Cotton, Peter. "When A Bar-Bell Bond Portfolio Optimizes Modified Excess Return" . Retrieved 20 June 2013.
  7. 1 2 Marjanovic, Boris. "Profiting From Market Randomness". Seeking Alpha.
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