On December 16, 2015, the Federal Reserve announced the first rate hike in nearly 10 years. As interest rates increase, bond prices generally fall. As interest rates fall, bond prices generally go up. Since bonds and interest rates have an inverse relationship, it is valuable to know some strategies to minimize volatility in your bond portfolio.

The barbell

The “barbell” term comes from the fact that this investment strategy looks like a barbell, heavily weighted at both ends and nothing in between. The barbell strategy focuses on the maturity dates of the securities in the portfolio by making sure they are both mostly near and at a distant date. This approach concentrates those dates at opposite ends of the spectrum. When there is a rate hike, short-term yields usually rise and the difference in the yield between short and long-term maturities decrease. The “in-between” of the barbell is known as the “belly” of the yield curve, which is most volatile after a rate hike.

Typically, bond funds are divided into three segments based on the average maturities of the bonds in the funds’ portfolios:

Short-term (less than 5 years)
Intermediate-term (5 to 10 years)
Long-term (more than 10 years)

Maintaining the barbell strategy is an active form of portfolio management, since the short-term bonds should be continuously rolled over into other short-term bonds as they mature and offers better diversification than a “bullet” approach, which is a strategy of investing in intermediate duration bonds only. The barbell reduces risk while continuing to have the potential to obtain higher returns.

The bond ladder

The bond ladder is a portfolio of individual bonds that mature on different dates where the maturities are equally divided, for example, across several months or years. The individual bonds are the rungs and the time between maturities is the spacing between the rungs. Bonds that mature get reinvested at regular intervals, taking advantage of potential rising rates.

Some advantages of purchasing several smaller bonds with different maturity dates rather than one large bond with a single maturity date are lower interest-rate risk and an increase in liquidity. The more liquidity an investor needs, the closer together the “rungs” in the ladder should be. This will help generate predictable cash flow.

The longer the space between the rungs, the higher the income is likely to be, since yields and interest rate sensitivity generally increase with longer maturities, however, the effect of ever changing market interest rates is also higher. Shortening the maturity dates generally reduce income, but this type of strategy creates opportunity to manage risk during times of interest rate hikes by giving the investor a greater ability to reinvest principal from maturing bonds at higher rates should they rise.

Carol Chaudet

(last updated 1/26/16)