Who Should Buy Long-Term Bonds?

Think about the last time someone gave you financial advice about bonds, specifically long-term government bonds. The advice was probably something like: if you're cautious, if you're close to retirement, if you can't stomach big swings in your portfolio — hold long-term bonds. They are safe. They are for conservative investors. That's the conventional wisdom, and it's been repeated so often that almost nobody stops to ask whether it's actually true, or more precisely, whether the reasoning behind it is right. John Campbell and Luis Viceira stopped to ask. What they found, published in a paper called "Who Should Buy Long-Term Bonds?", is that the conventional wisdom gets the conclusion roughly right but the reasoning almost entirely wrong. The reason conservative investors should hold long-term bonds has nothing to do with safety in the ordinary sense. It has to do with something much more specific — a mathematical property of how risk works across time. Understanding that distinction right changes how you think about bonds, about risk aversion, and about what investing conservatively means in the first place. The problem with standard investment models is that most of them are essentially myopic. They ask: given current expected returns, what should you hold today? A myopic investor optimizes for the short run, rebalancing constantly as conditions change, treating each period as if it were the only one that mattered. For a long-horizon investor — someone saving for retirement decades away, or a pension fund with obligations stretching thirty years into the future — that framing misses something fundamental. The investment environment itself can change. Real interest rates, meaning interest rates adjusted for inflation, fluctuate. If you're planning to live off your savings for the next forty years, the possibility that rates fall and stay low is not a minor inconvenience. It is an existential risk to your financial plan. Campbell and Viceira built a model designed to capture exactly that. Their investors are what the model calls infinite-lived — a mathematical idealization that stands in for genuinely long-horizon thinking rather than a literal assumption about immortality. The utility function they use is recursive utility, and this is worth unpacking because it's the conceptual engine of the whole paper. Standard utility functions conflate two things: how much you dislike risk right now, and how willing you are to trade consumption today for consumption tomorrow. Recursive utility, developed by Larry Epstein and Stanley Zin, separates those two preferences. That separation turns out to matter enormously, because it means you can ask: what does a highly risk-averse person want to hold, specifically because they're risk-averse about the future, not just about today? The model also incorporates stochastic interest rates — rates that evolve unpredictably over time according to a structured process — rather than assuming rates are fixed. This is what allows the model to generate a meaningful concept of intertemporal hedging. If rates were constant, there would be nothing to hedge against. The solution method Campbell and Viceira use is approximate and analytical, which matters for a reason that's easy to underestimate. Purely numerical models can tell you what the optimal portfolio looks like under a specific set of parameters, but they don't tell you why. An approximate analytical solution gives you a formula — something you can read and interpret — that shows how the optimal bond allocation depends on risk aversion, on the volatility of interest rates, and on the investment horizon. That interpretability is where the real insight lives. The insight is this. The model decomposes the demand for long-term bonds into two components. The first is myopic demand — the allocation a short-sighted investor would choose based purely on the current expected return premium that long bonds offer over short bonds. The second is intertemporal hedging demand — the additional allocation a long-horizon investor holds specifically to protect against the risk that real interest rates decline in the future. Here is the finding that upends the conventional story: as risk aversion increases, myopic demand shrinks. At the limit, a highly risk-averse investor has essentially zero myopic demand for any risky asset — they want nothing to do with return uncertainty in the short run. But hedging demand does not shrink. It stays. In fact, for investors with strong preferences for stable long-run consumption, the hedging motive for holding long-term bonds actually dominates. The most conservative investors — the ones with the highest risk aversion — hold long-term bonds not because those bonds feel safe day-to-day, but because they are the instrument best suited to insure against a future where the return on reinvested savings has permanently deteriorated. Think of it this way. If you're a conservative long-horizon investor and real interest rates fall sharply and stay low, every dollar you save going forward earns less. Your retirement plan, built on assumptions about what your savings will generate, is suddenly underfunded. Long-term bonds hedge that scenario because their prices rise when rates fall — so the investor who holds them gets a windfall exactly when the investment environment gets worse. It's not safety in the conventional sense. It's insurance against a specific future state of the world. This is where the distinction between bond types becomes critical. Campbell and Viceira are careful about what kind of long-term bond actually provides this hedge. The ideal instrument, in their model, is an inflation-indexed long-term bond — a bond that pays a guaranteed real return, insulated from changes in the price level. These bonds, known in the United States as Treasury Inflation-Protected Securities, or TIPS, directly hedge the risk of falling real interest rates because their return is defined in real terms. When real rates fall, the real value of the bond rises. The hedge is clean. Nominal long-term bonds — the standard government bonds that pay a fixed dollar amount — are a messier story. They can serve the same hedging function, but only when inflation risk is low. The problem with nominal bonds is that their yield conflates two things: the real interest rate and an inflation premium. When inflation is volatile, a rise in nominal yields might reflect higher real rates, or it might just reflect higher inflation expectations. The investor holding a nominal bond for its hedging properties can't easily tell those apart. In a high-inflation or inflation-uncertain environment, nominal bonds are an imperfect substitute for indexed bonds. They may hedge somewhat, but the insurance is leaky. Campbell and Viceira are clear on this: nominal bonds work as a hedging instrument mainly when inflation risk is low enough that nominal and real yields move together reliably. The practical implications of this framework are sharpest for institutions rather than individuals — pension funds managing long-dated liabilities, endowments planning distributions across decades, any entity whose financial health depends on what real returns look like thirty years from now. For those investors, the model says: your demand for long-term bonds is driven by hedging, not by yield-chasing or risk aversion in the everyday sense. And the type of bond matters as much as the duration. For individual investors, the insight reframes what it means to hold a conservative portfolio. The conventional advice — put bonds in your portfolio if you're risk-averse — isn't wrong, but it's incomplete in a way that could lead to the wrong bond. A retiree who holds long-term nominal bonds in a high-inflation environment is not getting the hedge the model prescribes. They're getting something noisier, something that depends on an assumption about inflation stability that may or may not hold. What Campbell and Viceira ultimately show is that conventional wisdom arrived at roughly the right destination by the wrong road. Long-term bonds do belong in conservative, long-horizon portfolios. But not because they're calm or boring or low-volatility in any simple sense. They belong there because they are the closest available instrument to a direct insurance contract against the specific risk that matters most to a long-horizon investor: a world in which the future offers worse returns than the present. For some investors — the most conservative, the most long-horizon — that's not just a reasonable bet. According to the model, it's the optimal one. The bond everyone assumes is the safe choice turns out to be safe for reasons that are much more precise and much more interesting than the advice usually lets on. This lecture was created by ennepō. Go to https://ennepo.ai to Discover, Create and Follow the latest research in your field. Read when you can. Listen when you want to.