Fixed Income Strategies

Managing fixed income portfolios requires understanding various strategies for different client objectives, market conditions, and risk tolerances.

Bond Portfolio Structures

Laddering Strategy

Definition: Building a portfolio of bonds with staggered, equally-spaced maturity dates.

Example: 10-Year Ladder

When bonds mature, the principal is reinvested in new 10-year bonds, maintaining the ladder.

Benefits of Laddering:

Best For: Conservative investors seeking steady income with reduced interest rate risk.

Barbell Strategy

Definition: Concentrating holdings in short-term AND long-term bonds with little or no intermediate-term bonds.

Example Structure:

Benefits:

• Short-term provides liquidity and reinvestment opportunities
• Long-term locks in higher yields
• Can adjust weights based on rate outlook
• More tactical than laddering

Best For: Investors willing to take a tactical approach and adjust based on interest rate expectations.

Bullet Strategy

Definition: Purchasing multiple bonds that all mature at approximately the same time.

Example: All bonds mature in Year 7

Benefits:

• Matches a specific future liability (college, retirement)
• Reduces interest rate risk through staggered purchases
• Maximizes cash available at target date

Best For: Investors with a specific future cash need (liability matching).

Strategy Comparison

Duration Management

Understanding Duration

Duration measures a bond's sensitivity to interest rate changes. It represents the approximate percentage price change for a 1% change in interest rates.

$\text{Price Change} \approx -\text{Duration} \times \text{Interest Rate Change}$

Key Relationships:

• Longer maturity → Higher duration
• Lower coupon → Higher duration
• Higher duration → More interest rate sensitivity

Duration Strategies

If Expecting Rates to RISE:

If Expecting Rates to FALL:

Duration Matching (Immunization)

Concept: Match portfolio duration to the client's investment horizon.

If a client needs money in 5 years:

• Set portfolio duration to 5 years
• As time passes, duration naturally shortens
• Rebalance to maintain target duration

Result: Interest rate changes have minimal impact on meeting the liability.

Credit Strategies

Credit Quality Spectrum

Credit Spread Strategies

$\text{Credit Spread} = \text{Corporate Bond Yield} - \text{Treasury Yield}$

Municipal Bond Strategies

Tax-Equivalent Yield

For high-bracket investors, municipal bonds may offer better after-tax returns:

$\text{Tax-Equivalent Yield} = \frac{\text{Municipal Bond Yield}}{1 - \text{Tax Bracket}}$

Example: 4% muni yield, 37% tax bracket

Step 1: Calculate the after-tax factor: 1 - 0.37 = 0.63

Step 2: Divide muni yield by after-tax factor: 4% / 0.63 = 6.35%

Result: A taxable bond would need to yield 6.35% to match the 4% muni after taxes.

In Practice

Strategy selection depends on:

• Interest rate outlook
• Income needs and timing
• Risk tolerance
• Tax situation
• Time horizon

On the Exam

Series 65 frequently tests:

• Understanding the three structures: ladder, barbell, bullet
• Knowing that duration measures interest rate sensitivity
• If rates expected to rise → shorten duration; if fall → extend duration
• Tax-equivalent yield calculation for municipal bonds

Key Takeaways

1. Laddering spreads maturities evenly—provides liquidity and reduces rate risk
2. Barbell concentrates in short AND long maturities—tactical approach
3. Bullet targets a single maturity date—matches future liabilities
4. Duration measures interest rate sensitivity
5. Rising rate expectations → shorten duration; falling rates → extend duration
6. Higher tax brackets benefit more from municipal bonds