Strategic Asset Allocation: Why Bonds Belong in Your Portfolio
Book: Systematic Fixed Income: An Investor’s Guide Author: Scott A. Richardson, Ph.D. Publisher: John Wiley & Sons, 2022 ISBN: 9781119900139
Chapter 2 answers the big strategic question: why should you even own bonds? Richardson breaks this down by looking at return drivers, risk premia, and how bonds fit alongside stocks in a real portfolio. The data goes back nearly a century, and the conclusions are clear.
Rates vs. spreads: where do bond returns come from?
The first thing Richardson does is split bond returns into two pieces. The “rates” component captures how much of your return comes from movements in risk-free interest rates. The “spread” component captures everything else, mainly credit risk and liquidity.
For safe government bonds, nearly 100% of returns come from rates. That makes sense. There is no credit risk, so the only thing driving returns is where interest rates go.
But as you move toward riskier bonds, the mix shifts. For investment-grade corporate bonds, rates still dominate but spreads matter more. For high-yield bonds and emerging market debt, the spread component becomes a major driver. For the period 2000 to 2020, the spread component explained most of the return variation for high-yield and emerging market bonds.
Why does this matter? Because it tells you what to focus on when investing in each category. If you are buying government bonds, your entire investment thesis is about where yields are headed. If you are buying corporate bonds, you should be focused on credit spreads, not interest rates. Trading corporate bonds is expensive, so do not pay those transaction costs just to express a view on rates when you could do it more cheaply with government bonds.
Over the 2000 to 2020 period, Sharpe ratios across fixed income categories were impressive. Government bonds delivered 0.71, corporate bonds 0.85, and securitized debt a remarkable 1.34. But a lot of that came from the tailwind of declining interest rates over those two decades. The rates component was strongly positive across the board.
The three fixed income risk premia
Richardson identifies three core sources of return in fixed income markets.
The term premium is what you earn for holding long-term government bonds instead of rolling short-term bills. Over the 1926 to 2020 period, the Sharpe ratio was 0.34. Not bad, and it compares well to the equity risk premium Sharpe ratio of 0.44 over the same stretch.
What drives long-term yields? Richardson follows a simple framework: current short-term rates, expected future short-term rates, and a residual “term premium.” Central banks control short-term rates and influence expectations. But longer-term forces matter too. The natural real interest rate (tied to economic growth), inflation expectations, inflation uncertainty, general risk aversion, and demand from big asset owners for safe assets. All of these push and pull on the term premium.
The credit premium is what you earn for holding risky corporate bonds over risk-free government bonds with similar cash flow profiles. Using data from 1926 to 2020, the Sharpe ratio for US investment-grade corporate bond excess returns was 0.48. That is actually better than both the term premium and the equity risk premium on a risk-adjusted basis.
The spread between corporate and government bond yields tells you the ex-ante price of credit risk. Higher spreads mean higher expected returns but also higher risk. The century of evidence supports a persistent credit risk premium, though it varies a lot through time. There have been decades where credit underperformed, and decades where it crushed it.
The prepayment premium comes from securitized markets, mainly mortgage-backed securities. MBS investors face the risk that homeowners will refinance their mortgages when rates drop, returning principal earlier than expected. This risk earns a premium. Over 1988 to 2020, the Sharpe ratio was 0.26 for MBS excess returns over duration-matched government bonds. But the average excess return was tiny, about three basis points annualized. The real money in MBS is in the less liquid corners, like premium and discount bonds far from par.
Why bonds diversify stocks
Now for the big portfolio question. Richardson shows that combining stocks and bonds improves risk-adjusted returns. A classic 60/40 portfolio (60% stocks, 40% bonds) generated a Sharpe ratio of 0.49 over 1926 to 2020, beating both stocks alone (0.44) and bonds alone (0.35).
The reason is straightforward. Stocks and bonds respond differently to the same economic forces. Growth shocks are good for stocks but bad for bonds (higher growth means higher rates, lower bond prices). Inflation shocks are bad for stocks but even worse for bonds. This difference in sensitivities creates natural diversification.
The stock-bond correlation has varied enormously over history. It has only been reliably negative for the past couple of decades. But even when the correlation is positive, it is almost never close to one, so you still get diversification benefits.
Richardson also looks at drawdowns. Stock drawdowns and bond drawdowns do not perfectly align in timing or severity. This is evidence of diversification even in the left tail of returns, which is where you need it most.
Using optimization over the full 1926 to 2020 period, the portfolio weights that maximize the Sharpe ratio are roughly 55% corporate bonds, 36% government bonds, and only 9% stocks. For the more recent 1973 to 2020 period, it shifts to 23% corporate, 63% government, and 14% stocks. Either way, bonds dominate the optimal allocation.
When you account for non-normal returns using the Sortino ratio (which only penalizes downside risk), the results are similar: 51% corporate, 39% government, 10% stocks. Fixed income is consistently important for portfolio diversification.
Do low yields kill the case for bonds?
This is the question everyone has been asking. If yields are at historic lows, does it still make sense to own bonds?
Richardson’s answer: yes, but understand why yields are low. Low yields are not random. They reflect low current interest rates, low expected future rates, and a compressed term premium. All of these are driven by real economic fundamentals: low inflation, slow growth, and accommodative central bank policy.
Just because yields are low does not mean they must revert higher. And even if you think rates will rise eventually, you need to ask: rise relative to what? The carry from an upward-sloping yield curve still provides positive expected returns, especially for investors who can maintain constant-maturity exposure through derivatives.
More importantly, even if fixed income looks relatively expensive by historical standards, so does everything else. Stocks are not cheap either. Fixed income still preserves its diversification benefit. Cutting your bond allocation to zero would leave your portfolio entirely dependent on equity risk.
For investors who can use leverage, the story is even stronger. You can scale up the lower expected returns from bonds while maintaining the diversification benefit. Risk parity strategies do exactly this.
The bottom line
Bonds are not just a parking lot for money. They offer three distinct risk premia (term, credit, prepayment), they diversify equity risk in ways that have persisted for nearly a century, and they remain strategically important even in a low-yield world. The key insight from this chapter is to be intentional about which returns you are harvesting. Use government bonds for rates exposure. Use corporate bonds for credit exposure. And do not pay extra transaction costs to get rate exposure through expensive credit instruments.
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