Wilmer Stith, vice president and fixed-income portfolio manager at Wilmington Trust Co., believes financial advisers might be selling their clients short by sticking to the tried-and-true bond-laddering strategy at this point in the market cycle.
Mr. Stith, who for the past several years has been spreading bond exposure across the yield curve to squeeze out as much yield as possible, is now shifting portfolios toward a barbell approach that reduces exposure to more interest-rate-sensitive intermediate-term bonds.
“In our opinion, by the end of next year, the Fed[eral Reserve] will begin to raise interest rates and I think in a rising-rate environment, putting money in a bond ladder would underperform a barbell approach,” he said.
The basic premise of a barbell bond strategy involves overweighting longer-term bonds, which are less sensitive to interest rate hikes, and also overweighting shorter-term bonds on the other end of the curve. The strategy also underweights exposure to intermediate-term 5- to 7-year bonds. Thus, a hypothetical barbell is created.
Shorter-term bonds, like intermediate-term bonds, are highly correlated to interest rate movements but they also provide a ready source of liquidity that would enable Mr. Stith to more easily take advantage of a rising-rate cycle by investing in higher-yielding bonds.
“There are instances where, if you're in a mechanized laddered portfolio, you might not be able to take advantage of nuances in very steep portions of the yield curve,” he said. “There are times when you might be able to get paid a lot more to be in the longer portion of the yield curve.”
InvestmentNews: Why do you believe a barbell approach is superior to a bond ladder in the current market environment?
Mr. Stith: Because we are anticipating higher interest rates as well as a slightly flatter yield curve. So we'll be overweighting the shorter end of the yield curve, buying floating-rate notes. That way we'll have a lot of dry powder on the shorter end and a slightly greater weighting on the longer end. When rates do move higher, we'll be able to deploy that cash on the longer end or keep rolling it on the shorter end.
InvestmentNews: What are the biggest risks of using a barbell approach for a fixed-income allocation?
Mr. Stith: The biggest risk would be that all the dry powder doesn't participate in a sudden rally in the intermediate part of the curve, or if the Fed would come out and say they are not planning to raise interest rates, or even that they are going to introduce more quantitative easing. The barbell-type structure would underperform the rally because of all the [short-term and low-yielding bond exposure].
InvestmentNews: Would you recommend a barbell strategy if you thought interest rates were going to stay at the current level for the next couple of years?
Mr. Stith: No, I'd use more of a bullet strategy that would include being more heavily invested across the yield curve. I'd want to be getting as much income as I could take advantage of, and that's essentially where we were for the past several years.
InvestmentNews: Does the barbell approach increase portfolio risk in exchange for added yield?
Mr. Stith: It does if I'm wrong, and our economic forecast proves to be too buoyant and all of a sudden we have a double-dip in recession.
Another scenario could be if suddenly inflation just explodes and the yield curve steepens. In that case, being overweight the long end would not be the best scenario for the barbell approach. But we don't expect that, because inflation is nowhere to be found. So we're willing to take that bet right now.
InvestmentNews: Is there a scenario in which you could imagine a bond ladder being the best strategy?
Mr. Stith: In an indecisive market where you don't really have a good rationale for either Fed policy, the trajectory of the economy or interest rates, and you want an innocuous type of bond ladder portfolio to take advantage of what you have.