Bond Investing Strategies
October 9, 2009
Bond ladders are a strategy where an investor purchases bonds with different maturity dates. It is the fixed income equivalent of dollar cost averaging. Let’s say for example, an investor wants to spread out the maturities of their bonds, but keep an average weighted maturity of 5 years. They can purchase five bonds with maturities of 1, 3, 5, 7 & 9 years. As the bonds mature, the investor will continue to purchase bonds at the longer maturity.
This helps the investor manage interest rate risk. When interest rates are rising, they can purchase into those bonds with the higher yields. If the rates are dipping, the investor will still purchase the bond and take advantage of the yields of the current bonds they own.
The further the maturity the date, the riskier the investment can be. Most bonds are issued with a maturity date 30 years out. If an investor has a longer timeframe, they can push out the maturity dates of the ladder for a possible higher yield.
Bullet Bond Strategy
This strategy is great for an investor who has a specific target date. For example, a child will be attending college in 15 years. The investor does not need the principal of their investments until that time. Bonds of different varieties and lengths, but with maturity dates around the same time 14-15 years out, can be purchased and held until maturity. There is no interest rate risk because the funds are not being used to purchase new bonds.
Another way to do this, or combine with the bullet strategy is to purchase zero-coupon bonds. These are bonds that are sold at a deep discount, but do not pay any interest. An investor can purchase these bonds and hold them until maturity and take advantage of the discount they received.
Barbell Bond Strategy
With a barbell, the investor purchases bonds with a short-term maturity date and then others 20-30 years out. You create an average weighted maturity somewhere mid-term. In this case, the investor is hoping to take advantage of the inverse relationship of price and yield. If the yield of the longer term bonds drops, the price of the actual bond on the market will go up. The investor will then sell those bonds and realize the gain in principal. They use the shorter term bonds for the interest.
All investment strategies have risks, but this one can hit you on both ends. The yield of short term bonds can drop and long term bonds can rise. If this happens, the barbell strategy becomes a loser for this investor.
One final strategy is to treat your bond portfolio as you do your stocks. Think of the maturities and credit ratings of bonds the way you do market cap for stocks. You can purchase a mixture of bonds based on industries, maturities, credit rating and geographic location. We won’t go into the details here because this takes a bit more work, and is not for the novice investor. It can have a rewarding effect on your portfolio though.
As with any investment, each of these strategies comes with varying degrees of risk and different tax implications so make sure you consult a financial professional before making any decisions.
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