Strategic Allocation: The Role of Corporate Bond Indices?

Abstract:     
We study the asset allocations among the three major security classes; stock, Treasury bond, and corporate bond indices. We employ a (new) model were liquidity plays an important role in forecasting excess returns. We document the significant utility benefits an investor gains by optimally including corporate bond indices in his portfolio. The benefits are bigger for lower-grade bonds. We also find that investment-grade indices are completely different from high-yield indices. One of the differences is that there exist positive "flight-to-liquidity" premia in investment-grade bonds, but we find no such premia in high-yield bonds. We calculate the portfolio behavior and the utility benefits for three types of investors, the "sophisticated", the "average" and the "lazy" investor. We provide practical portfolio advice on investing throughout the business cycle. We study how the total allocations and hedging demands vary with the business conditions. In addition, utilizing our model, we evaluate the significance of the liquidity variable information for the investor. We find that the liquidity information greatly enhances the investor's portfolio performance. Finally, further support in the optimality of the strategies is provided by calculating their in- and out-of sample realized returns for the last decade.

Keywords: Portfolio Choice, Strategic Allocation, Corporate Bonds, Liquidity, Flight-to-quality, Indices, Predictability, Hedging Demands, Risk Premia, Welfare Improvement, Utility Benefits, Business Cycle, Diversification

JEL Classifications: D10, D60, G10, G11, G12, G14, G19

Working Paper Series