If you bought a “risk-free” 91 day Federal Government of Nigeria (FGN) Treasury bills at 2%, what’s the worst that can happen? Well, there is no default risk thus the risk will be that rates rise to 10% for longer-dated bonds, and you are locked in at 2%.
In essence, you miss out because you are invested in a shorter cycle. The advantage to you is that you are only locked in for 91 days, thus you can buy long-dated bonds after 91 days
If you bought a 25-year “Risk-Free” FGN Bond due in 2045, what’s the worst that can happen? Again there is no default risk and no reinvestment risk. The risk is you are locked in at 10% for 25 years, you cannot sell without a loss sale, the advantage to you is that if the economy falls, you still get paid your 10% for 25 years
The word on investing is built around two major conventions:
- Asset Allocation
- Diversification
Asset allocation is the allocation of cash to asset classes like bonds and equities to meet a stated investment objective. Asset Allocation is one of the most important decisions that affect the performance of any portfolio. Simply put a faulty asset allocation ensures that the portfolio is unable to achieve its stated objective.
For instance, buying a fixed return 10 years US Treasury Bond ETF offers no capital appreciation to a portfolio that seeks to aggressively grow capital, the proper asset for this portfolio will be an ETF focused on small or medium cap equities.
Diversification is simply not putting all your assets in one basket. Diversification is important as it protects any portfolio from concentration risk. Every asset can be measured by how it correlates to the risk-free rate in any economy. To be “risk-free” the assets should have no default and even reinvestment risk. In building a portfolio every investor is seeking to buy assets that are perfectly correlated, meaning they respond differently to economic news.
Let’s look at inflation. A 10-year bond and an ETF investing in gold will respond very differently to a rise in inflation. The bond price falls as inflation rises, but the gold ETF will see an uptick. Thus, creating the right asset allocation schedule to match a stated investment objective and building a portfolio of assets that are positively correlated to each other is essential to ensuring the success of any portfolio.
Now back to the barbell strategy. A barbel is those weights with long poles and weights on each end, nothing in the middle. The strategy is simple, why bother to build a portfolio and diversify when there are just two outcomes possible, UP and DOWN.
In essence, take Nigeria, if I was to build a fixed income portfolio for a 60-year-old looking to earn a fixed return with a capital preservation objective, I would recommend 50% FGN Bonds, 25% Corporate Bonds Income and 20% REITS 5% Cash. This asset allocation is designed to preserve capital, hence the 50% Fixed Income allocation but also with 20% REITs to earn above “risk-free” return.
However, the barbell strategy says that diversification is faulty, rather it proposes investing in the two extremes of long duration risk and short risk, and no investment in the middle of the bar assets.
So rather in today’s market environment in Nigeria with a high inflation rate, the investor places simply two concentrated bets, a 50% bet on the economy booming and a 50% bet on economy stalling. Thus, a barbel strategy for my 60-year-old will be a 50% bet on long-term FGN 2045 bonds, and a 50% bet on short-term FGN Treasury Bills paying 2% to take advantage of the economy growing.
In this barbell fixed income portfolio, the investors are covered if the economy falls and interest rates fall as the investor has 50% in long-dated FGN bonds paying today 9.80% for 25 years. However, the investor is also covered if the economy booms and interest rates start to rise as his 50% is in short-dated Treasury Bills, which will see an increase in rates.
In essence, the investor gets to eat his bonds and have them.
