India’s sovereign yield curve has shown signs of flattening, if not inverting, recently. The Government of India’s 182-day and 364-day treasury bills, in recent auctions, have fetched yields of about 7.3 per cent. At the same time, 5-year government bonds are offering a 7.2-7.3 per cent yield and 10-year g-secs (government securities) are offering 7.3-7.4 per cent. In effect, whether you invest for 1 year or 10 years, bond markets are offering you the same annual rate of return.

Usually, when short-term interest rates catch up with long-term rates or exceed them globally, there’s a lot of erudite discussion about inverted yield curves and whether they portend a coming recession. But rather than try to make macro predictions using the shape of the yield curve, it may be best to see how one can use it to better the returns on their debt portfolio.

A good way to do this is through a barbell strategy.

How it works

If you’re a fitness enthusiast, you’d definitely know that the barbell is a pole with weights balanced at both the ends that help you test your lifting ability. A barbell strategy in a portfolio allows you to own assets positioned at two ends of the risk spectrum.

If you’re a bond investor in India today, there’s a tough choice to make.

You may be tempted to lock your money into long-term bonds such as 10-year g-secs, to capitalise on prevailing interest rates of about 7.4 per cent per annum. This is appealing because rates on 10-year g-secs were below 6 per cent even as recently as June 2020. But after you invest in these bonds, if rates head up to, say, 8.5 per cent, your g-sec holdings will lose value in the secondary market. You will also end up earning less-than-market rates until the bonds mature in 2033. This is interest rate risk. It is quite difficult to call the peak of any rate cycle and rate risk can dent your capital if you get the peak wrong.

Alternatively, if you think rates have some distance to go, you may pursue the opposite strategy and invest in 182-day treasury bills, which also offer you 7.3 per cent per annum. But if you do this, you can be hurt by reinvestment risk. If interest rates stop rising and, in fact, crash, you will have to settle for much lower returns, when your t-bills mature at the end of the year. Then you would have been much better off with the 10-year bond.

Clearly, unless you know with great conviction which way interest rates will move, it is difficult to choose one strategy over another.

Balance with a barbell

This is where a barbell strategy can come to your rescue. To implement it for your debt portfolio, you can divide your portfolio into two, and own, say, 50 per cent of it in 182-day treasury bills, and 50 per cent of it in 10-year g-secs. This way, if rates move up, your 182-day day treasury bills will mature quickly and you can buy the next tranche at higher yields. Yes, the 10-year g-secs you own will suffer reverses. But this will be made up by the gains on your short-term portfolio. In the reverse scenario of rates falling, your 10-year g-secs will offer high rates with gains, even as returns on your t-bills dip.

Apart from letting you balance interest rate and reinvestment risks, a barbell has other advantages too. It can help you manage portfolio liquidity, as the short-term holdings can be converted to cash pretty quickly, if your long-term bonds prove illiquid.

While the above illustration is a barbell strategy its simplest form, there are variations you can use. You can vary the combination of tenures used – use a mix of 91-day t-bils and 5-year g-secs, or 5-year and 15-year g-sec depending on where yields appear most attractive. Depending on how much upside or downside potential you see in rates, you can also go with unequal allocations. If you think 10-year g-sec yields can go from 7.4 per cent to 8 per cent before dipping, while they can fall to 6 per cent over time, then you may like to allocate more of your portfolio (say, 70 per cent) to the long-dated g-secs and less to t-bills. If you believe rates can go on to 8.5 per cent, you may prefer a higher allocation to t-bills than 10-year g-secs.

The barbell strategy does have two negatives. One, if the yield curve steepens — that is, short-term rates fall from current levels while long-term rates rise — then your portfolio can take a hit on both counts. A barbell strategy works best when the yield curve is flat or inverted.

Two, a barbell requires active management. As your short-term holdings mature, you will need to reinvest the proceeds, after taking a call on whether you’d like to stay put with similar instruments or move to longer-term ones. Taking the mutual fund route to owning short term bonds can save you some of the trouble of rebalancing, as the fund would automatically reinvest maturity proceeds in similar tenured bonds.

Real-life applications

Here are some real-life applications of the barbell you can try out.

·        Confused whether to lock into those 45-month fixed deposits from NBFCs that currently offer 7.7 per cent or keep powder dry for further FD rate revisions? Well, use a barbell and park half your surplus in 91-day treasury bills and the rest in the 45-month FD. If rates rise and hit mouth-watering levels of 8.5 per cent, you can switch your t-bill investments to FDs.  

·        Not sure if you should park all your debt money in longer-term debt funds such as target maturity funds or 10-year constant maturity funds? Well, park 70 per cent in these long-term funds and invest 30 per cent in money market mutual funds that only invest in t-bills.  

·        As a retiree, worried about whether you should lock into the post office Senior Citizens Savings Scheme at 8 per cent for five years or wait for even better rates to be announced two quarters down the line? Park half your corpus in it and the rest in t-bills so that you can later increase your deposits if the rates are reset.