We’re trying something new here — most of our content (and the investing content out there) falls into one of two camps:
Welcome to the first installment of the Informed Investor series. Our aim here is to chart a middle ground between those two points — explain complex concepts in plain English for people who are knowledgeable but not experts.
Today, we're unpacking the three primary strategies in fixed-income investments: the ladder, the barbell, and the bullet, each with its unique approach to managing risk and return in the bond market.
Picture a ladder, with its rungs representing bonds that mature at regular intervals. There are short-term, intermediate-term and long-term bonds much as you have low, middle and high rungs on your proverbial ladder. The ladder strategy involves purchasing bonds with varying maturities. As each bond matures, the principle is often reinvested in a new bond at the top of the "ladder." This approach offers a balance between risk and return.
Advantages: The ladder strategy by definition hedges against interest rate fluctuations. By having bonds mature at different times, you're not locked into a single interest rate (but you also aren’t locked into only long-term bonds that can lose value if interest rates move against it). It's akin to a steady, paced marathon runner — not sprinting but rather maintaining a consistent speed throughout the race.
Disadvantages: Laddering may require a larger investment upfront to purchase multiple bonds of different maturation time horizons. It can also be a bit rigid; once your money is tied up in various bonds, your ability to react quickly to market changes is slightly limited (imagine that same marathon runner unable to change pace when the terrain shifts). Now, if you’re investing for the long term, that downside is lessened (the same goes for if your fixed income portfolio is being actively invested)
The ladder strategy is our favorite, because based on our calculations (as well as others’), we believe it provides the best risk-adjusted total return opportunities (both in terms of tax liabilities as well as fluctuations in the yield curve).
In weightlifting, a barbell has weights on both ends with a long bar in between. The barbell strategy in investing involves holding a mix of short-term and long-term bonds, with little to no intermediate-term bonds. This strategy is designed to capture both stability and high yields.
Advantages: The beauty of the barbell strategy lies in its flexibility. Investors can take advantage of the stability of short-term bonds while still reaping the higher yields from long-term bonds — it's like a weightlifter who has balanced strength and endurance.
Disadvantages: This approach can be more sensitive to interest rate changes. If rates rise, the long-term bonds might lose value. Conversely, if rates fall, the short-term bonds won't benefit much. It's a strategy that requires active management and a keen eye on market movements. You’re also disregarding a potential tool in your tool chest by eliminating intermediate-term bonds from consideration, meaning your ability to hedge over a long time horizon is likewise diminished.
From our point of view, we tend to shy away from this strategy because once you get in, it is hard to get out (and when it comes to municipal bonds, you often have competition for supply). It’s also worth noting that to do this well, it requires constant management (read: more trading), which in turn can incur more capital gains taxes.
The bullet strategy involves buying bonds that all mature around the same time. Picture a bullet's trajectory: straightforward, with a clear target in sight (another term for this? Putting all your eggs in one basket). This approach is often used to align with specific future financial needs.
Advantages: The bullet strategy is easy to manage and understand. If you have a clear financial goal in sight, like a child's college tuition or a retirement date, this strategy lines up your investments with that timeline — it's like a target shooter with a bullseye in their scope from a fixed, known distance.
Disadvantages: The downside? Lack of flexibility and diversity. All your bonds are subject to the same market conditions at maturity. If rates are unfavorable at that time, your entire portfolio feels the impact. Using the same target shooter analogy, you know the distance and can see the target, but you didn’t factor in the wind before you took the shot… if it stays calm, you might hit the bullseye, but any gust could push your bullet well wide of the mark.
The strategy can work wonders if the basket you put all your eggs into moves in a positive direction… but if the basket gets dropped, all the eggs crack at once.
As you can see, there are distinct advantages to each strategy (with corresponding disadvantages). The question for you is: who are you, and what are you looking for? Put another way, what are your financial goals? What’s your risk tolerance? What’s your investment horizon?
Much as a marathoner, weightlifter, and target shooter have different strengths and skills, so too do investors have different needs (and strategies that are most likely to yield their preferred outcome). The key is to understand each strategy's nuances and align them with your personal financial goals.
IMPORTANT DISCLOSURES
The information contained in this communication has been designed for general informational, illustrative, and educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security. Moreover, the information provided is not intended to provide any investment advice whatsoever. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product, or any non-investment related content, made reference to directly or indirectly in this communication will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. No discussion or information contained herein serves as the provision of, or as a substitute for, personalized investment advice. To the extent that a reader has any questions regarding the applicability above to his/her individual situation of any specific issue discussed, he/she is encouraged to consult with the professional advisor of his/her choosing. City Different Investments is neither a law firm nor a certified public accounting firm and no portion of this content should be construed as legal, tax, or accounting advice.
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