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
| Year | Amount | Maturity |
|---|---|---|
| 1 | $10,000 | Year 1 |
| 2 | $10,000 | Year 2 |
| 3 | $10,000 | Year 3 |
| ... | ... | ... |
| 10 | $10,000 | Year 10 |
When bonds mature, the principal is reinvested in new 10-year bonds, maintaining the ladder.
Benefits of Laddering:
| Benefit | Description |
|---|---|
| Reduces interest rate risk | Not locked into single rate |
| Provides liquidity | Regular maturities provide cash flow |
| Smooths rate changes | Average into new rates over time |
| Simple to implement | Straightforward structure |
| Flexibility | Can use maturing bonds for expenses or reinvest |
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:
| Allocation | Maturity Range | Purpose |
|---|---|---|
| 50% | 1-3 years (short) | Liquidity, reinvestment flexibility |
| 0% | 4-7 years (intermediate) | Avoided |
| 50% | 8-10+ years (long) | Higher yields |
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
| Purchase Date | Maturity | Years to Maturity at Purchase |
|---|---|---|
| Year 1 | Year 7 | 6 years |
| Year 2 | Year 7 | 5 years |
| Year 3 | Year 7 | 4 years |
| Year 4 | Year 7 | 3 years |
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
| Feature | Ladder | Barbell | Bullet |
|---|---|---|---|
| Maturities | Evenly spread | Short and long only | Concentrated at one date |
| Purpose | Steady income, flexibility | Tactical positioning | Match future liability |
| Rate Risk | Moderate | Varies by weights | Reduced by staggered purchases |
| Complexity | Low | Moderate | Moderate |
| Liquidity | High (regular maturities) | Moderate | Low until target date |
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.
| Duration | Interest Rate Change | Approximate Price Change |
|---|---|---|
| 5 years | +1% | -5% |
| 5 years | -1% | +5% |
| 10 years | +1% | -10% |
| 10 years | -1% | +10% |
Key Relationships:
- Longer maturity → Higher duration
- Lower coupon → Higher duration
- Higher duration → More interest rate sensitivity
Duration Strategies
If Expecting Rates to RISE:
| Action | Rationale |
|---|---|
| Shorten duration | Reduces price decline when rates rise |
| Buy shorter-term bonds | Less sensitive to rate changes |
| Sell longer-term bonds | Avoid largest price declines |
If Expecting Rates to FALL:
| Action | Rationale |
|---|---|
| Extend duration | Maximizes price appreciation |
| Buy longer-term bonds | More sensitive to rate changes |
| Sell shorter-term bonds | Capture more upside |
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
| Rating | Category | Characteristics |
|---|---|---|
| AAA to A | Investment Grade (High) | Lower yield, very low default risk |
| BBB | Investment Grade (Low) | Moderate yield, low default risk |
| BB to B | High Yield (Speculative) | Higher yield, moderate default risk |
| CCC and below | Distressed | Highest yield, high default risk |
Credit Spread Strategies
Credit spread = Yield on corporate bond − Yield on comparable Treasury
| Economic Condition | Spreads | Strategy |
|---|---|---|
| Expansion | Narrow (low risk perception) | Reduce credit exposure |
| Recession | Wide (high risk perception) | Increase credit exposure (buy cheap) |
Municipal Bond Strategies
Tax-Equivalent Yield
For high-bracket investors, municipal bonds may offer better after-tax returns:
Tax-Equivalent Yield = Muni Yield ÷ (1 − Tax Bracket)
Example: 4% muni yield, 37% tax bracket
Tax-Equivalent Yield = 4% ÷ (1 − 0.37) = 4% ÷ 0.63 = 6.35%
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
- Laddering spreads maturities evenly—provides liquidity and reduces rate risk
- Barbell concentrates in short AND long maturities—tactical approach
- Bullet targets a single maturity date—matches future liabilities
- Duration measures interest rate sensitivity
- Rising rate expectations → shorten duration; falling rates → extend duration
- Higher tax brackets benefit more from municipal bonds
A bond ladder reduces interest rate risk by:
If an investor expects interest rates to rise, they should:
A bullet strategy is most appropriate for an investor who:
10.4 Return Calculations
Continue learning