Editor’s note: Christopher Baccella is a long-time columnist with Rethinking65. To read more of his articles, click here.
Christopher Baccella
Bonds often make up a significant portion of the assets in client accounts, particularly for those in or near retirement, and there are three basic strategies for managing them. This article is for advisors who want to get more active in managing their clients’ bond portfolios by using individual bonds.
Before we begin, just a friendly reminder that there are no hard-and-fast rules here. These are general concepts that do not require rigid adherence. What matters most are the needs of your clients.
While Wall Street is full of pundits and economic forecasts, no investor knows with certainty where interest rates will be at any given time in the future. For that reason, trying to time the market is a fool’s errand in the long run. So, even though the Federal Reserve has hinted in its recent comments that future interest rate cuts are coming, history teaches us that the market often overshoots in anticipation of rate cuts.
Also, there is always the possibility that inflation accelerates and/or the labor market re-tightens, causing the Fed to rethink its approach. This macro environment must be considered when recommending and implementing one of these strategies or taking a hybrid approach.
In a bullet strategy, an advisor would pick bonds with maturities clustered around a specific date range (e.g., five years out). The tight maturity dates would resemble a bullet hole on a timeline or graph. The strategy typically uses non-callable bonds (also sometimes referred to as bullets), which issuers can’t redeem early. While interest is paid over the life of the bonds, the entire principal value is paid at maturity.
The maturity dates can be selected based on market opportunities, such as a specific spot on the yield curve that appears attractive. Or maturities may be clustered to meet a client’s needs, such as a major purchase in a few years that will be funded with fixed income. For example, this approach could make sense if a client is saving for the purchase of a retirement home, college tuition or marquee vacation. A planned business transaction (such as buying out a partner) could be another use.
Pros
Can take advantage of specific market conditions or specific needs.
Cons
Limited cash flow generation. (Clients receive coupon payments only, no principal payments until maturity.)
Significant reinvestment risk because all bonds mature at the same time and interest rate levels will be unknown until maturity.
Clients have locked in yields, often for several years, and as a result may experience higher volatility and liquidity risk.
Barbell Strategy
As the name implies, in a barbell strategy, a significant portion of the portfolio is kept short, while another chunk is invested in longer bonds.
For instance, in the current inverted interest rate environment, with short-term Treasury bills yielding more than longer-dated Treasuries, an advisor may wish to keep a significant portion of the client’s assets in short-term, highly liquid T-bills. In the other half, the advisor may then purchase longer-dated corporate bonds or municipal bonds that lock in today’s higher yields.
A barbell can insulate yields against falling interest rates. While the name “barbell” implies balance, there is no requirement that the portfolio be exactly 50/50 weighted between short-term and longer-term bonds. The advisor can tilt in one direction or another to meet liquidity requirements and/or market opportunities.
Most recently, I’ve found this strategy to be helpful with new clients who have transferred in long-dated bonds. It has afforded me ample near-term liquidity for distributions and investment opportunities while managing their longer-dated holdings.
Pros
Relatively simple to manage and comprehend.
Liquidity and cash flows are available at the short end of the portfolio.
Long-term bonds lock in today’s rates, while T-bills take advantage of the inverted yield curve.
Maturing T-bills can offer the ability to opportunistically lock in higher rates.
T-bills are among the safest and most liquid securities in the world.
FDIC-insured CDs can be used as well; they sometimes offer a premium to T-bills.
Cons
Some exposure to falling rates as short-term T-bills mature.
Bond-laddering Strategy
A bond ladder is also a relatively simple concept. The advisor, often after consulting with their client, buys bonds that mature every year. For example, a bond ladder may stagger maturities from one to five years out in equal allocations. Each time a “rung” on the ladder matures, it is then replaced by purchasing a new five-year bond.
A laddered bond portfolio tends to be my default approach, though it is often customized to meet a client’s unique situation. Additionally, for clients in the distribution phase of their retirement, I can take some principal to meet their cash needs and reinvest the remaining principal. I’ve typically found clients understand this concept, especially when presented in a chronological format.
Pros
Intuitive and relatively easy to understand.
Cash flows are generated from coupon and principal payments.
Modest reinvestment risk. By making new purchases annually, the strategy dollar-cost averages across the interest rate cycle. In a five-year ladder, for example, about 20% of the portfolio needs to be reinvested each year.
Eliminates the need or desire to time the interest rate cycle.
Cons:
Strict adherence to a laddered approach may ignore other opportunities or dislocations in the bond market.
‘Know What You’re Buying’
When recommending and implementing these strategies, advisors should remain aware of the increased risk and complexity of today’s interest rate environment. Many of today’s new issue bonds are callable (redeemable) by the issuer before maturity. Some bonds are callable almost immediately, while others may offer a few years of call protection.
Most U.S. Treasury bonds are bullets (not callable, with a defined maturity date), while many government-sponsored agency (GSA) bonds are callable. Some of these GSAs are callable after three months, even if they have a final maturity date 20 years out. It’s critical to know what you’re buying.
The fact that some bonds are callable and others are not creates some complexity in managing client portfolios in the current environment. When buying callable bonds, your client should receive a yield premium in exchange for the increased risk of uncertain cash flow they have purchased.
Finally, keep in mind that even in today’s low-to-zero-commission environment, there may be hidden trading costs when selling bonds. This is especially true for small positions and/or thinly traded issues in the corporate or municipal bond realms. To reduce portfolio turnover and trading costs, consider keeping ample liquidity in one or more money market, mutual or exchange-traded fund(s). Those funds can also be used as part of a core-satellite approach (aka a completion strategy) to place tactical bets on duration (interest rates) or credit quality. This may be a topic for a future article.
The three basic bond strategies — bullets, barbells and ladders — may sound like a children’s board game but may well have a place in your clients’ well-diversified investment portfolio.
Christopher Baccella, CFA®, is a wealth advisor with Mariner Wealth Advisors. He develops personalized wealth management solutions to help wealth management clients achieve their goals and grow and protect their wealth. He also provides investment management services to institutional clients. Chris has over 16 years of experience in the wealth management industry. He can be reached at chris.baccella@marinerwealthadvisors.com. Click here for disclosures.
