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Bond Ladders and Optimal Portfolios in Dynamic General Equilibrium

Abstract

This paper examines investors' portfolios in a dynamic (Lucas-style) general equilibrium model with heterogeneous agents. The celebrated two-fund separation theorem from static portfolio analysis generalizes, under the classical preference assumptions, to our dynamic model only when a consol is present or if the endogenous prices for bonds of different maturity allow for a trading strategy that replicates the consol. We give sufficient conditions on stock-payoffs that ensure that replication is possible but also argue that these conditions are quite restrictive. If the conditions do not hold, if all bonds have finite maturity and do not span the consol, then we show that equilibrium will deviate, often significantly, from two-fund separation. Nevertheless, the bonds play an important role in that they may complete the financial market. However, the optimal portfolios often imply unrealistically large trades in bonds of long maturity. The main result of the paper demonstrates that investors choosing two-fund-like portfolios with bond ladders that approximately replicate consols do almost as well as traders with equilibrium investment strategies -- our model may give a rationale for bond-ladders as a popular bond-portfolio management strategy.

Type

Working Paper

Author(s)

Kenneth L. Judd, Felix Kubler, Karl Schmedders

Date Published

2007

Citations

Judd, L. Kenneth, Felix Kubler, and Karl Schmedders. 2007. Bond Ladders and Optimal Portfolios in Dynamic General Equilibrium.

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