Ch6. Bond Portfolio Strategy — Diversification and Yield Optimization

Why a Bond Portfolio Is Necessary

Problems with single-bond investing:

Maturity concentration risk: large maturities clustering at one point in time
Interest rate risk: reinvestment risk if everything is short-term
Liquidity problem: hard to convert to cash if holding only long-term bonds

The portfolio approach systematically diversifies these risks.

The Three Core Bond Portfolio Strategies

1. Ladder Strategy

Structure:
Allocate equal amounts across multiple maturities
Example: 20% each in 1-year, 2-year, 3-year, 4-year, 5-year bonds

How it works:
1-year bond matures → recover principal → reinvest in 5-year bond
→ always maintain a 1–5 year portfolio

Advantages:
- Automatic adaptation to interest rate changes (cost averaging)
- Regular cash flows secured
- No complex judgments required

Disadvantages:
- Misses short-term yield opportunities during sharp rate rises
- Limits gains on long-term bonds during sharp rate falls

2. Barbell Strategy

Structure:
Concentrate only on short-term (1–2 years) + long-term (10–30 years)
Hold no intermediate maturities

Example: 50% short-term + 50% long-term

Advantages:
- Short-term: maintain liquidity + rapid reinvestment when rates rise
- Long-term: maximize capital gains when rates fall

Disadvantages:
- Long-term bonds suffer if intermediate-term rates rise
- More volatile than the ladder strategy

3. Bullet Strategy

Structure:
Concentrate maturities at a specific target date
Example: planning to buy a house in 5 years → concentrate on 5-year bonds

Advantages:
- Optimized for a specific funding target
- Maximizes returns if rate forecast is accurate

Disadvantages:
- Reinvestment yield falls if rates are low at the target date
- No diversification benefit due to single-point concentration

Stock-Bond Allocation Principles

The Traditional 60/40 Portfolio

Stocks 60% + Bonds 40%

Historical performance (1990–2020):
- Average annual return: ~8–9%
- 2022: rapid rate hikes pushed both asset classes lower (stress test)

Modern adjusted allocation:
- Adjust flexibly based on risk tolerance
- 100 minus age = stock allocation (traditional rule of thumb, for reference)

Bond Allocation Guide by Age

Age Group	Bond Allocation	Rationale
20s–30s	10–20%	Long investment horizon, higher risk tolerance
40s	20–40%	Transitioning to a balanced portfolio
50s	40–60%	Strengthening capital preservation
60s+	50–70%	Prioritizing stable cash flows

Bond Portfolio Rebalancing

When Rebalancing Is Needed

Time-based: periodically every 6 months or 1 year
Threshold-based: when the allocation drifts more than 5 percentage points from target
Event-based: when a turning point in the interest rate cycle is identified

Executing a Rebalance

Example:
Target: Stocks 60% / Bonds 40%
Current: Stocks 68% / Bonds 32% (after equity rally)

→ Sell 8% of stocks, buy 8% of bonds to restore target
→ Be mindful of taxes on capital gains triggered in the process

Managing Duration in a Bond Portfolio

Set target duration:
Expecting rising rates → shorten duration (increase short-term bond weight)
Expecting falling rates → extend duration (increase long-term bond weight)
Uncertain environment → neutral position

Duration calculation:
Portfolio duration = weighted average of individual bond durations
Example: 50% in 2-year bonds + 50% in 10-year bonds = 6-year duration

A Practical Portfolio Example

40-year-old professional, $100,000 bond portfolio

Applying the ladder strategy:
Short-term (1–2 years): government bonds $20,000
Medium-term (3–5 years): government bonds $30,000
Medium-long-term (7 years): high-grade corporate bonds (A+ rated) $20,000
Long-term (10 years): government bonds $20,000
Inflation-linked bonds (TIPS): $10,000

Expected return: 3.5–4.5% per year (varies with interest rate environment)
Duration: approximately 5.5 years

Ladder: diversification and automatic adaptation / Barbell: short-term liquidity + long-term gains / Bullet: concentrate on a target date 60/40 portfolio: its limits were tested in 2022 by rapid rate hikes → flexible adjustment required Duration management: expecting rate rises → shorten; expecting rate falls → extend