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Inflation and the Role of Bonds in Investor Portfolios

Author

Listed:
  • Zvi Bodie
  • Alex Kane
  • Robert L. McDonald
Abstract
This paper explores both theoretically and enirically the role of nominalbonds of various maturities in investor portfolios in the U.S. One of its principal goals is to determine whether an investor who is constrained to limithis investment in bonds to a single portfolio of money-fixed debt instruments will suffer a serious welfare loss. Our interest in this question stemsi n part from the observation that many employer-sponsored savings plans limit a participant's investment choices to two types, a common stock fund and a money-fixed bond fund of a particular maturity. A second goal is to study the desirability and feasibility of introducing a market for index bonds (i.e. an asset offering a riskless real rate of return) in the U.S. capital markets.The theoretical framework is Merton's (1971) continuous time model of consumption and portfolio choice. Our measure of the welfare gain or loss from a given change in the investor's opportunity set is the increment to current wealth needed to completely offset the effect of the change. A novel feature of our empirical approach is the method of deriving equilibrium risk premia on the various asset classes. We employ the variance-covariance matrix of real rates of return estimated from historical data in combination with "reasonable" assumptions about net asset supplies and the economy-wide average degree of risk aversion to derive numerical values for these risk premia. This procedure allows us to circumvent the formidable estimation problems associated with using historical means, which are negative during some subperiods.Our main results are: (i) There can be a substantial loss in welfare for participants in savings plans offering a choice of only two funds, a diversified stock fund and an intermediate-term bond fund. Most of this loss can be eliminated by introducing as a third option a money market fund.(2) The potential welfare gain from the introduction of private index bonds in the U.S.capital market is probably not large enough to justify the costs of innovation.The major reason for the small gain is that one month bills with their small variance of real returns are an effective substitute for index bonds.

Suggested Citation

  • Zvi Bodie & Alex Kane & Robert L. McDonald, 1983. "Inflation and the Role of Bonds in Investor Portfolios," NBER Working Papers 1091, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:1091
    Note: ME
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    References listed on IDEAS

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    1. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
    2. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    3. Grossman, Sanford J & Shiller, Robert J, 1981. "The Determinants of the Variability of Stock Market Prices," American Economic Review, American Economic Association, vol. 71(2), pages 222-227, May.
    4. Fischer, Stanley, 1975. "The Demand for Index Bonds," Journal of Political Economy, University of Chicago Press, vol. 83(3), pages 509-534, June.
    5. Zvi Bodie, 1979. "Inflation Risk and Capital Market Equilibrium," NBER Working Papers 0373, National Bureau of Economic Research, Inc.
    6. Frederick R. Macaulay, 1938. "Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and Stock Prices in the United States since 1856," NBER Books, National Bureau of Economic Research, Inc, number maca38-1.
    7. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-257, August.
    8. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
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    Cited by:

    1. Pindyck, Robert S, 1984. "Risk, Inflation, and the Stock Market," American Economic Review, American Economic Association, vol. 74(3), pages 335-351, June.
    2. LuisM. Viceira & John Y. Campbell, 2001. "Who Should Buy Long-Term Bonds?," American Economic Review, American Economic Association, vol. 91(1), pages 99-127, March.
    3. Benjamin M. Friedman & Mark Warshawsky, 1985. "Annuity Prices and Saving Behavior in the United States," NBER Working Papers 1683, National Bureau of Economic Research, Inc.
    4. Haselmann, Rainer & Herwartz, Helmut, 2010. "The introduction of the Euro and its effects on portfolio decisions," Journal of International Money and Finance, Elsevier, vol. 29(1), pages 94-110, February.
    5. Barsky, Robert B, 1989. "Why Don't the Prices of Stocks and Bonds Move Together?," American Economic Review, American Economic Association, vol. 79(5), pages 1132-1145, December.
    6. Benjamin M. Friedman, 1986. "Implications of Government Deficits for Interest Rates, Equity Returns, and Corporate Financing," NBER Chapters, in: Financing Corporate Capital Formation, pages 67-90, National Bureau of Economic Research, Inc.
    7. Haselmann, Rainer & Helmut, Herwartz, 2005. "The Introduction of the Euro and its Effects on Investment Decisions," Economics Working Papers 2005-15, Christian-Albrechts-University of Kiel, Department of Economics.
    8. Zvi Bodie & Alex Kane & Robert L. McDonald, 1983. "Why Are Real Interest Rates So High?," NBER Working Papers 1141, National Bureau of Economic Research, Inc.
    9. David Eagle, 2005. "The Pareto-Efficient Relativity of Relative Risk Aversion," Microeconomics 0509004, University Library of Munich, Germany.
    10. Zvi Bodie & Alex Kane & Robert L. McDonald, 1986. "Risk and Required Returns on Debt and Equity," NBER Chapters, in: Financing Corporate Capital Formation, pages 51-66, National Bureau of Economic Research, Inc.
    11. Benjamin M. Friedman, 1984. "Implications of Government Deficits for Interest Rates, Equity Returns and Corporate Financing," NBER Working Papers 1520, National Bureau of Economic Research, Inc.
    12. Philipp Karl Illeditsch, 2018. "Residual Inflation Risk," Management Science, INFORMS, vol. 64(11), pages 5289-5314, November.

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