What Is a Dumbbell?
A dumbbell investment strategy, also known as a “barbell” investment strategy, involves buying a combination of bonds with short and long maturities in order to provide a steady and reliable income stream. It is intended to offer the flexibility of short-term bonds in addition to the generally higher yields associated with longer-term bonds.
- The dumbbell approach consists of buying a mixture of short-term and long-term bonds.
- It is the opposite of the so-called bullet approach, which involves buying bonds of intermediate maturities.
- The advantage of the dumbbell approach is that it can offer both relatively high yields and reasonable liquidity.
How Dumbbells Work
To implement a dumbbell strategy, an investor would selectively purchase bonds with short-term and long-term maturities, avoiding securities with intermediate terms. The idea behind this approach is to benefit from the best aspects of both short-term and long-term bonds.
Typically, long-term bonds offer higher yields, as compensation for the increased inflation and interest rate risks associated with the long-term structure. On the other hand, short-term bonds give investors more liquidity and hence less exposure to those risks. In exchange, short-term bonds generally offer lower yields.
By using a dumbbell strategy, investors seek to obtain an optimal balance of these two advantages. If interest rates start to rise, the short-term bonds can be reinvested into higher-yielding bonds when they mature. Likewise, if rates fall, the long-term bonds will continue to give a steady and increasingly attractive yield. Another advantage of this approach is that the investor’s short-term bonds can be used to cover any unanticipated large purchases or emergencies, whereas a portfolio of only long-term bonds would remain illiquid for many years.
One of the downsides of the dumbbell strategy is that it must be actively managed, since the investor must regularly acquire new bonds to replace their short-term holdings. If interest rates decline, the interest income on the portfolio may not be high enough to justify the additional time required to implement the strategy. Moreover, the relatively high volume of transactions makes the dumbbell approach more expensive in terms of fees than other more passive approaches.
In the context of institutional fixed income, the strategies of using "bullet" or "barbell" portfolios often have a different intent. This is because the construction of multiple portfolios using different maturities along the yield curve can each achieve the same or similar cashflows or yield to maturity (YTM) to the others.
What will change is the modified duration of those portfolios, an important measure of price sensitivity and risk exposure for large institutional holdings which means very little to the smaller investor. While an essential risk management tool for fixed-income professionals, it has little practical impact on smaller portfolios.
Real-World Example of a Dumbbell
Dorothy is a successful entrepreneur who has recently decided to retire. After selling her business, she obtained a large cash position of $2 million. Eager to generate a return on this cash, Dorothy decided to invest half of her cash holdings into a bond portfolio following the dumbbell investment strategy.
Dorothy decides to invest half of her bond allocation, meaning $500,000, into short-term bonds with maturities of only 3 months. Although these bonds offer a very low interest rate, they give Dorothy the opportunity to respond quickly if interest rates rise, allowing her to then reinvest the proceeds into higher-yielding bonds upon expiration.
Moreover, the bonds’ short maturities mean that she will regularly have access to her cash, reducing her risk of illiquidity from emergencies or unanticipated expenses. For the remaining $500,000, Dorothy invests in long-term bonds with maturities of between 10 and 30 years. Although these bonds offer very limited liquidity, they also offer significantly higher interest rates than her three-month holdings, increasing the total income she can generate on her portfolio.