Replace Your Bond Ladder with a Barbell

Physician's Money Digest, December 2005, Volume 12, Issue 16

A traditional laddered bond portfolio is a passiveinvestment strategy that follows a simple,established system. For example, to structure a10-year laddered $100,000 portfolio, an investor purchases$10,000 worth of bonds that are due each yearover the next 10 years. Each year, the proceeds frommaturing bonds are used to purchase a 10-year bondfor the portfolio. This strategy requires very little managementskill and reduces volatility by accepting loweryields in the process. The principal from maturingshort-term (low-yielding) bonds is reinvested into newlonger term (higher-yielding) bonds.

Investment professionals who recommend bondladdering argue that short and intermediate bondscapture most of the return of longer bonds, but withless volatility and regardless of which direction interestrates move. However, most individual physician-investorsare left unaware of two potential shortcomingsof this investment strategy.

Laddering Limitations

Laddered bond portfolios are typically structuredwith 5-to 10-year time horizons, and the realities of theyield curve (the shorter the maturity, the lower theyield) suggest that investors will rarely have an opportunityto lock in higher yields associated with longermaturity bonds. To maximize the overall yield in anybond portfolio, investors must take advantage ofchanges in interest rates by capturing positively slopingyield curves and benefiting from higher yields in longerterm maturities. Despite the media buzz regarding theinverted yield curve on US Treasury bonds, municipalbonds nearly always have a positive yield curve and canrepresent significant opportunities for higher returns.

Apart from their inherent financial shortcomings,bond ladders can also have built-in structural liabilitiesof which physician-investors may be unaware. For example,many bank trust departments and an increasingnumber of financial advisors charge investors a feefor "managing"a laddered portfolio, which is largelyan automated transaction. These unwarranted feesreduce the overall return of a laddered portfolio.

Building Portfolio Muscle

One alternative to a laddered bond portfolio is topurchase specific fixed-income instruments that representthe best values in the market, regardless ofmaturity. Similar to the selection of equities, thisstrategy provides investors with opportunities to buyand sell assets as their values change over time. Someinvestors, however, are uncomfortable with the marketrisks related to this approach.

An effective bond investment compromise—combiningthe protection of a ladder with the higheryields of individual long maturity bonds—is called a"barbell"strategy. Barbells can be structured in anumber of ways, perhaps with half the portfolio ladderedfrom 1 to 5 years and the balance in long-term,higher yielding bonds. Rather than long-term bonds,half the portfolio might be in bonds that representthe best value at that time, regardless of maturity.Consult with your financial advisor to determine thebest strategy for your investing needs.

Barry H. Zucker is president & CEO of J.B. Hanauer & Co, a full-service

financial services firm founded in 1931, specializing in

building and preserving wealth for affluent investors and recognized

for its expertise in fixed-income investment. He welcomes

questions or comments at 800-631-1094 or bzucker@jbhanauer.com. For more information, visit www.bondsearch123.com.