Why barbell bond portfolios can outperform when rates rise

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Profiting from bond portfolios when rate hikes are coming

The federal funds rate has been at unprecedented, near-zero levels since December 2008. The Fed had lowered rates to bring the economy out of the Great Recession. It also embarked on three rounds of quantitative easing (or QE) to improve credit conditions and boost consumption and investment. But now, the US economy is gaining momentum. The Fed’s confident about the economy’s prospects—so much so that it’s eased up on the liquidity pedal by ending its monthly bond buying program (QE3) last month.

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QE3 had resulted in the Fed purchasing $1.7 trillion in longer-term Treasuries and mortgage-backed securities since October 2012. The unprecedented level of liquidity injected in financial markets, along with an improving economy, resulted in the S&P 500 Index (SPY) rising by ~45% since September 2012. Bond (HYG)(LQD) markets benefited too, as the higher liquidity implied by the program brought down yields and raised bond prices.

Part 1.1

 

Fixed income markets and rising rates

The Fed’s now looking at the second stage of monetary tightening—normalizing the federal funds rate. This is expected to occur sometime in 2015. The timing depends on how soon the Fed meets its employment and inflation targets.

Bond (BND) prices fall as rates rise. Fixed income (TLT) investors must prepare for a period of rising rates next year, which could come as early as Q1. Some strategies can provide bond investors with positive returns, even in a period of rising rates.

What’s a barbell fixed income strategy?

You can visualize a barbell with weights stacked at both ends and a flat handle in between. That’s what your figurative bond portfolio would look like with bond investments stacked at the short-term and long-term ends. There would also be less or nil exposure to medium-term or intermediate-term maturities.

This portfolio strategy, called a “barbell strategy,” can provide superior performance when rates rise. Read about the benefits of fixed income barbells in the next part of this series.

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