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There are three popular strategies for investing in bonds - the barbell, the bullet, and the laddered bond strategy.
Let's begin with the barbell strategy. With this strategy one would buy only short term issues and long term issues, without purchasing anything in between. The long term bond allows you to lock in the highest yield available, while the short term issues provides capital in the near term should bonds take a real beating and other types of investments have become more attractive. Perhaps now is the time for a managed bond portfolio and you would rather have a bond fund, or maybe cash is the place to be. Either way you will have the cash available to do with as you choose. If the bond market is still strong you may just want to purchase more short term bonds again.
The next strategy is the lesser known bullet strategy. When using the bullet strategy you will buy only bonds that mature at the same point in time, such as when you retire and will need the money. You may want to lessen your exposure to interest rate risk at the same time so every two years you will buy a new issue. Here is how you will implement this strategy.
Bond When to buy maturity
1 Today 10 year
2 2 years 8 year
3 4 years 6 year
Now you have successfully lessened your interest rate risk by no buying everything on the same date, and at the same time you have saved money for that all important date. Maybe this is when you are going to retire. Or maybe this is when your son will start his first year of college. You can of course buy as many issues as you like and extend out the maturity date as far out as you need. That is, in a nut shell, the bullet strategy.
Now lets go over the laddered bond strategy. Ladders are a great strategy for staggering the maturity of your bond investments and for setting up a schedule for reinvesting them as they mature. With a laddered portfolio you have the choice of reinvesting back into the bond market if rates are favorable, or going elsewhere with your cash if you choose to invest in something else. With this strategy you will be capturing the higher rates at the end of the yield curve as well with your long bonds.
When I set up a laddered bond portfolio for someone I like to choose six different issues, starting with a short bond, one that matures is two years, then stagger them out to twenty or twenty five years. How far you go out on a bond should be determined by the yield curve.
In a typical market the shorter the bond, the less the risk, therefore the lower the yield. There are times when the yield curve will be nearly flat of even inverted.
Lets talk about a normal yield curve. At the beginning of the yield curve your current yield you are able to capture will be fairly low, maybe two percent. The farther out you go on the curve, or the longer the investment is outstanding the higher your rate of return. A thirty year bond may pay five percent while a fifteen year bond may pay three percent. Having said that, often there is a point where the curve flattens out and that is where you want your longest bonds to mature. If one can get a five percent at twenty years there is no point in having a thirty year, more risky bond that pays, say five point two percent. The difference is not enough to justify having your bonds for ten more years.
That is the yield curve at it's most basic. Ask your financial advisor or CPA about the yield curve before buying bonds. Look for another more in-depth article on the yield curve, in the near future.