Portfolio Design: A Modern Approach to Asset Allocation

SUMMARY—KEY FEATURES OF BONDS

Above all else, bond returns depend upon inflation. In the long run, inflation affects the yield offered on bonds. This link can be illustrated by studying the variation over time of interest rates and inflation in the United States or by studying the close link between average interest rates and average inflation rates in the industrial countries. Inflation also profoundly affects the real returns on bonds, especially in periods when inflation is rising or falling significantly as in the 1970s and 1980s. Real bond returns were unusually low in the 1970s (and even earlier) because bond yields failed to keep pace with inflation expectations. Similarly, the sharp downturn in inflation since the early 1980s has led to unusually high real bond returns.

Bond returns in the United States vary by type of bond. Over the last few decades, the bond market has evolved extensively as new classes of securities have emerged. The introduction of mortgage-backed bonds in the 1970s, high-yield debt in the 1980s, and other securitized debt in the 1980s and 1990s has greatly expanded the scope of the U.S. bond market. The returns on these new classes of bonds have fallen in line with those of the existing Treasury and corporate issues, at least when measured on a risk-adjusted basis. But their introduction has allowed investors to further diversify their portfolios. The gains from diversification are reasonably large.

Diversification into foreign bonds also makes some ...