Barbells, Ladders, and Avoiding Bondage
By Andrew Gordon

Investing right now – when the economy is so shaky – may sound mighty risky. In fact, your main concern is probably not how much money you can make … but how well you can keep your existing money safe. There’s nothing wrong with that. It’s in unpredictable times like these that an old Wall Street adage applies: It’s not the return ON your investment but the return OF your investment that should be foremost in your mind.

If your primary concern is to protect your money, there’s really only one place to go. U.S. government bonds. They may be boring. They may give underwhelming returns. But they’re safe. And they have the full backing of the U.S. government. And that still means something.

The biggest challenge in buying bonds? Locking in an attractive interest rate. When you buy a government bond, you’re loaning the government money. The longer the government keeps your money, the higher the interest rate it needs to offer you.

If you were negotiating for that interest rate, you’d say something like, "If you want my money for two years, you’ll need to pay me 1.8 percent. But if you want it for 10 years, you’ll have to pay me 3.5 percent."

That is what actually happens, except the government gets the message not from words but from the actions of millions of people buying and selling government bonds every day.

The risk you’re taking with government bonds isn’t that they’ll go bad. It’s that inflation will eat away at your earnings. If you’re making 3.5 percent interest on a bond investment but inflation is going up at the rate of 4 percent, for all practical purposes you’re losing money.

That’s not a good way to save, is it?

Consumer prices are climbing at a 4.1 percent clip right now. And investors who believe that number badly underestimates the true rate of inflation (as I do), should be starting to do more selling than buying of bonds. (Don’t worry. If you’re interested in buying rather than selling, I’ll show you how in a moment.)

This is the self-regulating mechanism of the market. As investors sell, the price of bonds goes down – just as selling pressure pushes the price of stocks down.

And as bond prices go down, their yields go up. As yields rise and become more attractive, buyers are once again drawn into the bond market.

"Bond interest rates" (not the original yield but the "yield to maturity") are constantly moving up and down in response to this buying and selling. When you buy a bond, it’s hard to be sure whether the interest rate you’re getting will be better or worse than it will be next year or the year after. But your interest rate on that bond (the original yield) is locked in as soon as you make the purchase.

However, the price of your bond will fluctuate – as rates move up and down. So you should not put all your eggs in one basket.

Diversifying your bond portfolio is just as important as diversifying your stock portfolio. In addition to diversifying by sector, you also diversify by time.

There are two good ways to do this. You could ladder your bonds. Or you could barbell them. Let’s look at laddering first.

Building a Bond Ladder

Building a bond ladder is easy. The objective is to be in a position to reinvest your bond returns every one or two years.

Let’s say you have $50,000. Through your broker, you could buy a series of five 10-year bonds. The first series matures in 2009. You buy $10,000 worth. The second series matures in 2011. You put down another $10,000. The third matures in 2013, the fourth in 2015, and the fifth in 2017. (This is a two-year ladder but you can do a one-year ladder and have money coming due each year for reinvestment or emergency.)

And what do you do with the money you get when you redeem the bond maturing in 2009? You invest it in a bond maturing in 2019. And so on.

That means when interest rates are going up, you’re in a position to buy. When they’re going down, you’re also buying. For some people, that sounds very safe. For others, it may sound a little crazy.

Why invest in bonds maturing in 2019 if you’re getting a less attractive rate than, say, for 2017? Why not wait? But rates for bonds maturing in 2020, or 2022, or 2025 could continue to head down. You may be waiting a long time for nothing.

And if they reverse and head up? Well, you’ll be in a position to capture those higher rates as you move up the ladder (in years). In 2011, you could reinvest the money from your maturing bonds into bonds that are maturing in 2021. And so on.

Laddering is a very safe way to spread the interest rate risk you get with bonds. And you can do it with decent success with U.S. bonds. But I’d rather have you laddering with bonds issued by certain foreign governments – like Australia. Like U.S. government bonds, they’re government-backed with virtually no chance of defaulting. But many carry a much higher interest rate than U.S. government bonds. Australia’s is about 50 percent higher (300 basis points or three percentage points higher).

The only risk you’re taking is with the foreign exchange rate. You want the other country’s currency to be getting stronger against the U.S. dollar.

Why? Let’s assume you’ve bought $1,000 worth of Australian bonds. Your 6 percent interest should come to $600, right? But it’ll amount to less than that if the dollar gets stronger against the Australian dollar.

You see, your payment has to be converted from Australian to American dollars. If the Australian dollar weakens against the American dollar, it will buy fewer dollars. Say the Australian dollar goes down 10 percent against the U.S. dollar. Your $600 will also drop by 10 percent (or $60) to $540. But that’s still better than the $390 you’d get from a 10-year U.S. government bond. And 10 percent is a huge drop for a currency to take. Usually, the drops are a quarter of a percent or a third of a percent at a time.

That’s why I like foreign government bonds so much. You do better with them even under the worst currency-exchange scenarios. And if a currency is steadily moving against you, you have loads of time to call your broker and ask him to sell the bond.

Barbelling Your Bonds

A simpler way to play interest rate risk is by barbelling. With that same $50,000, instead of splitting it five ways, you’re splitting it in half.

Let’s say you think the yields on 10-year bonds will be going up. (Of course, you can’t be sure.) You invest $25,000 in the 10-year. The other $25,000, you invest in short-term bonds (maturing in, say, 18-36 months). You get stable income on one end and flexibility with the ability to reinvest in higher rates on the other end.

At the end of the 18-36 months, you can revisit the 10-year bonds. If the yields are more to your liking, you invest. If not, you have the option of reinvesting the $25,000 again in short-term bonds, and waiting another year or two to see where the 10-year rates are.

Right now, a lot of people think U.S. 10-year government bond yields will be going up, because these bonds are sensitive to the rate of inflation. And inflation is becoming a more serious threat. But if you have money you’d like to invest in bonds right now and you can’t wait, then barbelling may be a sensible strategy for you.

With risk spreading into unexpected places - like municipal bonds, bond auctions, and even the money market - government bonds are one of the truly safe havens left for investors.

And remember, you can employ these two techniques - laddering and barbelling - just as effectively with overseas bonds as U.S. bonds.