Why Bonds Belong in Your Portfolio: Strategic Asset Allocation Explained

Chapter 2 asks a question every investor should care about. Why put money in bonds at all? Stocks get more attention, they’re flashier, and over long periods they tend to return more. So what’s the case for fixed income?

Richardson makes that case here. And it’s a strong one.

Breaking Down Bond Returns

Before we can talk about why bonds matter, we need to understand where their returns actually come from. Richardson splits bond returns into two pieces: the “rates” part and the “spread” part.

The rates piece comes from changes in interest rates. When rates move, bond prices move in the opposite direction. If you hold a bond and rates drop, your bond goes up in value. This effect depends on duration. Longer duration means bigger price swings when rates change.

The spread piece captures everything else. Credit risk, liquidity risk, and other factors specific to the bond issuer. For a government bond from a stable country, the spread piece is basically zero. For a risky corporate bond, it can be huge.

Richardson looked at six categories of bonds from 2000 to 2020, ranging from safe government bonds to high-yield corporate bonds. Here’s what jumped out. For the safest bonds, nearly all of the return came from rates. For the riskiest bonds, the spread piece became more and more important.

This matters because it tells you what you’re actually betting on. If you buy government bonds, you’re betting on interest rates. If you buy corporate bonds, you’re also betting on whether the company can pay you back.

The Term Premium: Getting Paid for Patience

The term premium is the extra return you get for holding long-term government bonds instead of just rolling short-term bills over and over.

Think of it this way. If you buy a 10-year government bond, you’re locked into today’s yield for a decade. A lot can happen in that time. Inflation could spike. Interest rates could jump. Your bond’s price would drop and you’d be stuck holding it. That uncertainty is real, and investors demand compensation for it.

Richardson explains that long-term bond yields are made up of three things: current short-term interest rates, expectations of where those rates will go, and the term premium (which is the leftover piece that captures inflation uncertainty, risk aversion, and demand from big players like pension funds).

Central banks control short-term rates directly. They also influence expectations through forward guidance. But the term premium is driven by broader market forces.

So does holding long-term bonds actually pay off? Richardson pulls data going back to 1926. Over the 1926 to 2020 period, US government bonds earned a Sharpe ratio of 0.34. That’s lower than stocks at 0.44, but it’s still solid for an asset that’s far less volatile. There were rough patches. Long-term bonds underperformed for decades in the middle of the 20th century. But the last few decades of declining rates delivered great returns.

The question people keep asking is whether low yields mean bonds aren’t worth it anymore. Richardson pushes back on that. Low yields don’t mean yields must rise. Yields are low because inflation is low, growth is low, and central banks are keeping rates low. Those conditions can persist. The term premium is still there to be harvested.

The Credit Premium: Getting Paid for Default Risk

Corporate bonds pay more than government bonds because there’s a chance the company doesn’t pay you back. That extra yield is the credit spread, and the extra return you earn from it is the credit premium.

Richardson frames it simply. Two bonds have the same cash flows. One is from the government (basically zero chance of default). The other is from a corporation (some chance of default). The corporate bond trades at a lower price, which means a higher yield. The difference is the spread.

Has that spread actually turned into extra returns over time? Yes. Using data from 1926 to 2020, investment-grade corporate bonds earned a Sharpe ratio of 0.48. That’s better than both the term premium (0.34) and the equity risk premium (0.44) over the same period.

Richardson is careful to note some caveats. Older data might miss some defaults, which would make the premium look bigger than it really was. And the data only covers US investment-grade bonds, so it doesn’t capture the broader universe of high-yield and international corporate debt. But the pattern is consistent across geographies and rating categories. The credit premium is real.

The Prepayment Premium: Mortgage-Backed Securities

There’s a third premium hidden in the bond market that most people don’t think about. It lives in the securitized market, especially mortgage-backed securities (MBS).

These bonds are pools of home mortgages packaged together and sold to investors. The US agencies (Fannie Mae, Freddie Mac, Ginnie Mae) guarantee them, so credit risk isn’t the main concern. The risk is prepayment. When interest rates drop, homeowners refinance their mortgages. That means investors get their money back earlier than expected, right when rates are low and they can’t reinvest it at attractive yields.

This prepayment risk commands a spread over government bonds. Richardson cites research showing that the prepayment premium has a Sharpe ratio of 0.26 from 1988 to 2020. That’s smaller than the term or credit premium, but it’s still meaningful. And the best opportunities are in the less liquid corners of the MBS market, where prepayment risk is most concentrated.

Why Bonds and Stocks Are Better Together

Now for the part that ties it all together. Each of these premiums (term, credit, prepayment) has earned positive returns on its own over long periods. But the real question is whether they add value when combined with stocks.

Richardson walks through the classic 60/40 portfolio: 60 percent stocks, 40 percent bonds. Using data from 1926 to 2020, the 60/40 mix earned a Sharpe ratio of 0.49. That’s higher than stocks alone (0.44) or bonds alone (0.35). Same money, better risk-adjusted returns.

Why does this work? Stocks and bonds respond differently to the same economic forces. Stocks love economic growth. When business conditions improve, stock prices rise. Bonds? Not so much. Improving growth often leads to higher interest rates, which pushes bond prices down.

But when things go bad, bonds shine. Recessions bring lower interest rates and flight to safety, which pushes bond prices up. Meanwhile, stocks are getting crushed.

This opposite reaction to growth shocks is the key to diversification. It’s not that bonds never lose money. They do. It’s that they tend to lose money at different times than stocks. Over the past couple of decades, the correlation between stocks and bonds has actually been negative. When stocks dropped, bonds went up.

Richardson also shows this through drawdown analysis. Looking at the worst peak-to-trough declines for stocks and bonds over the past century, the timing rarely lines up perfectly. Stocks have bigger, nastier drawdowns. Bonds have smaller, shorter ones. And they don’t always happen at the same time.

What About Low Rates?

The elephant in the room is low interest rates. If yields are already low, doesn’t that mean bonds can’t protect you anymore?

Richardson addresses this directly. Yes, lower yields mean lower future returns from bonds. That part is just math. But lower yields don’t automatically mean yields will rise. And even in a low-yield environment, the yield curve is still upward-sloping. There’s still carry to be earned from holding longer-dated bonds.

For investors who can use leverage, bonds remain just as attractive as ever. You can scale up a modest return to match what stocks deliver, while keeping the diversification benefit. For investors who can’t use leverage, bonds are less exciting than they used to be, but they still belong in the portfolio. The diversification benefit doesn’t disappear just because yields are low.

Richardson ran an optimization exercise to find the best portfolio weights across government bonds, corporate bonds, and stocks. Over the full 1926 to 2020 period, the optimal allocation was 55 percent corporate bonds, 36 percent government bonds, and only 9 percent stocks. The numbers shift depending on the time period, but fixed income consistently gets a large allocation.

The Bottom Line

The case for bonds in a portfolio isn’t about bonds being exciting. It’s about math. Term premium, credit premium, and prepayment premium all have a century (or close to it) of evidence showing positive risk-adjusted returns. And when you combine them with stocks, the total portfolio gets better.

Stocks and bonds respond differently to the economic cycle. That’s what creates the diversification benefit. It’s been true for a hundred years. It works during drawdowns. And it works even when yields are low.

The question isn’t whether bonds belong in your portfolio. They do. The question is how much, and which types. That’s what the rest of this book builds toward.

Previous: Previous: Setting the Stage for Fixed Income Investing Next: Next: Tactical Asset Allocation in Fixed Income Part of the series: Systematic Fixed Income: An Investor’s Guide Book by Scott A. Richardson, Ph.D. | ISBN: 9781119900139 | Publisher: John Wiley & Sons, 2022