Labor income and the demand for long-term bonds

The riskless nature, in real terms, of inflation-linked bonds has led to the conclusion that inflation-linked bonds should constitute a substantial part of the optimal investment portfolio for long-term investors. This conclusion is reached in models where investors do not receive labor income during the investment period. Sincesuch an income stream is often indexed with inflation, labor income in itself constitutes an implicit holding of real bonds. As such, the optimal investment in inflation-linked bonds is substantially reduced. By extending recently developed simulation-based techniques, we are able to determine the optimal portfolio choice amonginflation-linked bonds, nominal bonds, and stocks for investors endowed with an indexed stream of income. We find that the fraction invested in inflation-linked bonds is much smaller than reported in the literature, the duration of the optimal nominal bond portfolio is lengthened, and the utility gains of having access to inflation-linked bonds are substantially reduced. We investigate as well the robustness of our results to time-variation in bond risk premia, the riskiness of labor income, and correlation between labor income risk and financial risks.

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