Investing Daily

Investors typically follow a ladder strategy when building their fixed-income portfolios. By purchasing a number of bonds along the maturity spectrum, from short to long term, they aim to minimize interest-rate risk and improve yields. 

When the yield curve shifts gradually, the ladder approach almost always outperforms fixed-income portfolios that focus on either end of the maturity spectrum.

Today’s market presents significant challenges, including an extremely steep yield curve and uncertain economic outlook.

In this environment bond investors would be better served by a barbell strategy, investing only in issues at the short-term and long-term ends of the curve.

Why pursue such a strategy? One of two scenarios will play out over the next year or so.

Either US economic activity will remain flat, exerting downward pressure on the yields offered by long-term bonds, or anemic growth will continue until the Federal Reserve tightens interest rates to prevent inflation, forcing short-term rates higher.

In either case a barbell approach would outperform a laddered portfolio; in both scenarios one end of the yield curve would move more rapidly than the other, while maturities near the middle of the curve would remain static.

Although the yield curve could approach its high if there’s another economic shock, the odds favor a gradual flattening in the coming months. In the unlikely event that the yield curve does steepen, bond investors who follow a barbell strategy will take more of a hit than those who opt for the traditional ladder approach.

The evolution of fixed-income exchange-traded funds (ETF) that target a variety of maturities has made it much easier for individual investors to pursue ladder and barbell strategies.

“Ladders or Barbells” includes my favorite ETFs for municipal, corporate and Treasury bonds, organized by average maturity. Although Treasuries carry the least risk, note that the entries for municipal and corporate bonds all hold investment-grade debt, with an average credit rating of “AA” or better. And our recommendations all feature low expense ratios--the highest one comes in at a paltry 0.2 percent.

Although the consensus opinion holds that municipal issuers are in dire straits, much of this fear is overblown.

And the three ETFs that focus on municipal debt maintain diversified portfolios that will limit exposure to an individual defaults.

At current levels, municipal bonds represent one of the best values in the bond market; spreads relative to Treasuries appear to offer adequate compensation for the additional risk. And the group’s tax status could make them a compelling investment when the Bush-era tax cuts sunset.

These ETFs make it easy for investors to execute a ladder or barbell strategy. For investors seeking to ladder their Treasury investments, consider including SPDR Barclays 1-3 Month T-Bill (NYSE: BIL) and iShares Barclays 10-20 Year Treasury (NYSE: TLH).