Although the yields offered on longer-term bonds are only modestly higher than those with short maturities, investors should still consider extending the average maturities of their bond holdings.
A bond barbell is a tactical strategy that focuses on bonds with two different types of maturities—some short-term bonds and some longer-term bonds.
A bond ladder is a type of “all-weather” strategy that is meant to help provide predictable income with the flexibility to reinvest bonds as they mature.
When the yield curve is flat, as it has been recently, investors often ask us: Why invest in long-term bonds when one can get similar yields with safer, short-term investments like U.S. Treasury bills or money market funds?
It’s a logical question—after all, the 10-year Treasury note currently offers a yield that’s barely above the three-month Treasury bill yield. It may seem counterintuitive to tie up your money for longer for only modestly higher yields.
The slope of the yield curve is relatively flat
Source: Bloomberg, as of 4/29/2019
However, we believe investors should consider increasing the average duration of their bond holdings despite the flat yield curve, for reasons we’ll discuss below, and that two strategies can help: bond barbells and bond ladders.
The pitfalls of a short-term bias
Short-term yields have risen sharply from near-zero levels a few years ago, and the Federal Reserve hiked rates four times in 2018 alone. This can make it tempting to focus on very short-term securities.
However, the Fed has since stepped back from its aggressive pace of rate hikes, and is now projecting a patient approach going forward. It’s unlikely that short-term interest rates will rise any time soon, and based on market expectations there’s now a greater chance of rate cut than a rate hike. According to Bloomberg, the implied probability of a rate hike this year is less than 1%, with the probability of a rate cut coming in at more than 50%.1
The market is forward-looking, so if it becomes clear that the next move by the Fed is in fact a rate cut, it may be too late to lock in higher yields. Given that outlook, investors should consider modestly extending the average maturities of their bond holdings.
Barbells provide exposure to both short- and long-term yields
A bond barbell is a tactical strategy that focuses on bonds with two different types of maturities—short-term and longer-term. Today, we prefer maturities of three years or less for the short-term holdings, paired with maturities in the seven- to 10-year area.
By concentrating on shorter and longer-term bonds—with nothing in between—the maturity allocation can somewhat resemble a barbell.
A bond barbell can be a good compromise for investors hesitant to move out of short-term investments and into longer-term bonds, as it holds a little of both. The chart below highlights our preferred barbell maturities. Specifically, we prefer investors avoid what’s known as the “belly” of the yield curve, or maturities in the three- to seven-year range, where yields are lower than Treasury bill yields.
Intermediate-term yields are now lower than both short-term and long-term yields
Source: Bloomberg as of 4/29/2019.
A bond barbell offers two key benefits today:
1. Locking in yields. It’s true that long-term yields currently aren’t much higher than short-term yields, but investors can know with certainty the yields they’ll be earning over the next seven to 10 years. Short-term Treasury bills, on the other hand, face elevated reinvestment risk: It’s not known in advance what yield you’ll earn when that short-term investment comes due and you reinvest the proceeds.
2. Diversification benefits. Treasury bills can help provide liquidity and relative price stability, but they won’t offer much in terms of price appreciation if yields fall or the stock market declines. All else being equal, bonds with longer maturities are more sensitive to changing interest rates than those with shorter maturities. Because bond prices and yields move in opposite directions, intermediate- and long-term bonds may see larger price increases if bond yields fall due to slower growth concerns or stock market declines.
This illustration below compares historical total returns of Treasury bills and five-year Treasury bonds during periods when the stock market suffered steep declines over a 12-month period. With the exception of high-inflation periods during the 1970s, intermediate-term Treasuries generally outperformed Treasury bills when stocks were falling.
Intermediate-term Treasuries generally have outperformed Treasury bills when stocks have fallen sharply
Source: Schwab Center for Financial Research with data from Morningstar, Inc. Indexes used are the S&P 500 Index (stocks), Ibbotson Intermediate-Term Government Bond Index (bonds), and the Ibbotson US 30 Day Treasury Bill Index. Total returns reflect the trailing 12-month total return, ending the month shown on the horizontal axis. Total returns include price change and interest or dividend income. Past performance is no guarantee of future performance.
Ladders provide predictable income and flexibility
A bond ladder is a portfolio of individual bonds with staggered, or “laddered,” maturities. While a bond barbell is more of a tactical strategy that may depend on the shape of the yield curve and future Fed policies, a bond ladder is a type of “all-weather” strategy that is meant to help provide predictable income with the flexibility to reinvest bonds as they mature.
Picture a ladder with several rungs and spacing between the rungs. The individual bonds are the rungs and the time between maturities is the spacing between the rungs.
Source: Schwab Center for Financial Research
A bond ladder is built with two primary goals in mind:
1. Reducing risk. By staggering maturity dates, investors avoid getting locked into a single interest rate. For example, say an investor bought a single five-year bond. If interest rates rose two years from now, then the bond would still be paying interest at the lower rate.
However, a ladder helps smooth out the effect of fluctuations in interest rates because there are bonds maturing every year, quarter or month, depending on the number of rungs and spacing of the ladder. When a bond matures, an investor could reinvest that principal in a new longer-term bond at the end of a ladder. If bond yields have risen, they’ll benefit from a new, higher interest rate and keep the ladder going. If rates have fallen, they’ll still have higher-yielding bonds in the ladder.
2. Managing cash flow. A bond ladder also helps to manage cash flows for particular needs. For example, because many bonds pay interest twice a year on dates that generally coincide with their maturity date, investors can structure the ladder so that they receive monthly income from the various coupon payments. Bonds in the ladder also mature periodically, and investors can use the proceeds to reinvest into new bonds to extend their ladder or as a source of cash to fund spending.
A bond ladder can help take the guesswork out of bond investing. If they keep the ladder intact by reinvesting the proceeds of maturing bonds to the end of the ladder, investors can ride out any potential movement of interest rates and don’t need to worry about timing the market.
What to do now
While it can be tempting to focus on very short-term bonds, considering their yields have risen from their near-zero levels of a few years ago, they leave investors vulnerable to shifts in Fed policies.
Consider modestly extending the average duration of your bond holdings by building a bond barbell or a bond ladder. A barbell can be a good compromise for investors who are reluctant to move out of short-term fixed income securities, while a ladder is a good all-weather strategy that can reduce risk and help manage cash flow whether interest rates are rising or falling.
For help or guidance on how to implement a bond barbell or bond ladder strategy, you can speak with a Schwab fixed income specialist. If you’re interested investing in bond funds, you can find potential investment options with Schwab’s Mutual Fund OneSource Select List or ETF Select List.
1Source: Bloomberg, as of 4/29/2019