Barbell strategy definition
A strategy in which the trader simultaneously invests in short-term and long-term fixed income instruments
What is barbell strategy?
The barbell strategy entails investors setting up a portfolio composed of two types of assets on the opposite end of the risk/reward spectrum. They hold one group of investments with very low risk and another group of high-risk profile investments. In accordance with the strategy, investors should stay away from instruments with medium risk/reward levels.
The strategy is commonly used in bond investing. Investors can earn a profit for a certain bond maturity without actually being exposed to maturity. Through the barbell strategy, investments are structured in a way that their average return will be at least as high as the return offered by medium-term maturity. For instance, an equal amount of money can be invested in three-year bonds and bonds with a maturity of more than 15 years. The amount of money allocated for each group doesn't have to be the same, the portion assigned to each group depends on investors' judgment.
Barbell strategy meaning
The objective of the strategy is to provide a higher return than the return earned on intermediate maturity bonds without taking additional risk. High-yield long-term maturity bonds increase the return earned, while short-term, low risk (investment grade) bonds decrease the risk and offer liquidity to investors.
Holding an asset with short maturity requires constant monitoring and analysis of market changes. Moreover, the funds from short-term instruments are usually invested over and over again.
Barbell strategy explained
The barbell strategy provides certain benefits for investors, but it also comes with some risks. Benefits of barbell strategy are:
Risk profile and exposure - portfolios have a higher degree of diversification and, instead of being exposed to one maturity, they get a similar return through exposure to different maturities.
Interest rates changes – with the barbell strategy, investors are able to benefit from an increase in interest rates. Holding short-term bonds in a portfolio provides them with the opportunity to reinvest money into new bonds at the increased interest rates.
Let’s assume that an investor has exposure to a three-year bond yielding 2 per cent. Due to an increase in market interest rates, the three-year bond yields 5 per cent. The investor will wait for the three-year bond in the portfolio to mature and use the funds to purchase a new three-year bond with a 5 per cent yield.
Higher liquidity – short term bonds have a lower maturity period. Hence, investors can maintain a certain level of liquidity while creating an opportunity for higher returns. The liquidity is augmented because short-term instruments mature in a shorter period.
Risks associated with the barbell strategy consider the exposure with long-term bonds. Long-term bonds are characterised by higher volatility compared to short-term instruments. Consequently, upward changes in interest rates during the maturity period can cause a fall in the prices of bonds. Investors could record a loss from their long-term position if they liquidate the bonds prior to their maturity.
One danger for investors is a market situation when long-term yields increase at a faster pace compared to yields generated by short-term bonds. Accordingly, long-term bond prices decrease.