Bond Portfolios and Two-Fund Separation in the Lucas Asset-Pricing Model

The two-fund separation theorem from static porfolio analysis generalizes to dynamic Lucas-style asset model only when a consol is presemt. If all bonds have finite maturity and do not span the consol, then equilibrium will devitate, often significantly, from two-fund separation even with the classical preference assumptions. Furthermore, equilibrium bond trading volume is unrealistically large, particularly for long-term bond, and would be very costly in the presence of transaction costs. We demonstrate that investors choosing two-fund portfolios with bond ladders that approximately replicate consols do almost as well as traders with equilibrium investment strategies. This result is enhanced by adding bonds to the collection of assets even if they are not necessary for spanning. In the light of these results, we argue that transaction cost considerations make portfolios using two-fund separation and bond laddering nearly optimal investment strategies.