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Bonds in a Portfolio

Credit vs Treasury Allocation

Pomegra Learn

Credit vs Treasury Allocation

Treasuries are risk-free in nominal terms but offer lower yields. Credit bonds (corporates, municipal, emerging market) offer higher yields but carry default risk. The allocation between the two defines your bond portfolio's character: safe haven or income engine.

Key takeaways​

  • U.S. Treasuries offer near-zero default risk but yield 3.8–4.2% (as of 2024), limiting return potential
  • Investment-grade corporate bonds yield 5–6%, offering a 1.5–2% premium for low default risk
  • High-yield bonds yield 7–9%, offering a 3–5% premium for significant default risk
  • The optimal allocation depends on portfolio size, leverage, and your ability to survive drawdowns
  • Most portfolios benefit from 60–80% Treasuries, 20–40% credit

The Treasuries case: risk-free in nominal terms​

The entire edifice of a balanced portfolio rests on the assumption that Treasuries are the world's risk-free asset. The U.S. government has the power to print dollars, so it cannot default in nominal terms (only in real terms, through inflation). This makes Treasuries the theoretical foundation of all risk-return calculations.

For a conservative investor, the logic is simple: own Treasuries, accept the 4% yield, and let equity upside come from the equity portion of the portfolio. A 30/70 portfolio split 30% stocks (VTI), 70% Treasuries (a Treasury ladder or TLT, SHV for maturity choice) will preserve capital in most downturns and deliver roughly 3–4% real return over decades.

The cost of this safety is opportunity cost. In the bond market, the safest bonds yield the least. A 10-year Treasury yields roughly 4.0% while a 10-year corporate bond (same maturity, issued by Apple, Microsoft, or Johnson & Johnson) yields 4.8–5.2%. The 0.8–1.2% extra is the credit spread—compensation for the tiny risk that the company might default.

Investment-grade credit: the efficient middle​

Investment-grade (IG) corporate bonds are companies rated BBB or higher by rating agencies (Moody's, S&P, Fitch). These are blue-chip companies: Apple, Coca-Cola, Johnson & Johnson, Microsoft, Berkshire Hathaway. They are profitable, have low leverage, and have survived multiple market cycles.

The default rate on IG bonds is remarkably low. Since 1970, the average IG bond has had roughly 0.2% probability of default per year. Over a 10-year holding period, the cumulative probability of default is roughly 2%. So if you own an IG bond and hold it to maturity, the probability that you lose principal to default is very small—much lower than the probability that you get rear-ended in a car accident.

This makes IG bonds (typically yielding 5–6% in 2024) an exceptional risk-adjusted investment. You get a 1.5–2% yield pick-up over Treasuries for assuming almost no real risk (the actual default probability is tiny, and recovery rates on IG bonds in default are high, around 50–70%).

Most core bond allocations can safely be 60–70% IG credit. A bond portfolio could be:

  • 40% Treasuries (TLT, Treasury ladder, SHV)
  • 60% IG corporate (LQD, BND-which contains 30% IG, or individual bonds)

Or:

  • 50% Treasuries
  • 50% IG credit (individual bonds, LQD, or BND)

Both of these allocations offer 4.3–4.8% yield with minimal default risk.

High-yield bonds: the risk-on trade​

High-yield (HY) bonds are issued by companies rated BB or lower—speculative companies with high leverage, cyclical earnings, or weak competitive positions. The default rate on HY bonds is much higher: roughly 2–4% per year on average, with spikes to 8–10% during recessions.

HY bonds yield 7–9% to compensate for this default risk. The expected return (taking into account default losses) is roughly 5–6% after you account for the 2–3% expected loss to defaults.

This makes HY bonds economically unattractive to most investors. You are accepting significant default risk to earn a return that is barely above IG bonds after accounting for losses. HY bonds make sense only in three scenarios:

  1. You have a high risk tolerance and 20+ year time horizon. Over very long periods, the default cycles average out and HY bonds deliver on their promised higher return. If you are 25 years old and can weather a 40% drawdown, 10% allocation to HY is reasonable.

  2. You are in the late cycle of an economic expansion. When unemployment is low (under 4%), corporate earnings are strong, and credit spreads are tight (under 3%), HY bonds have lower default risk and are closer to a fair value. In 2023–2024, HY spreads were near 5%, which is attractive.

  3. You are using HY as a tactical trade, not a core holding. If you believe the economy will stay strong for 2–3 years, an overweight to HY for that period captures the spread—then you rebalance back to your strategic allocation when the cycle shows signs of turning.

For most buy-and-hold investors, HY bonds are not worth the concentration risk. A 60/40 portfolio doesn't need HY when it can get 5.5% from IG bonds and Treasuries.

2008: the stress test of credit allocation​

The 2008 financial crisis was the acid test for credit allocation strategy. Let's compare three approaches:

100% Treasuries approach: A bond investor in 100% Treasuries gained 15% total return in 2008 (bonds rallied as rates plummeted). Simple and safe.

60% Treasuries, 40% IG approach: IG corporate bonds fell 15–20% in 2008 as credit spreads widened from 100bps to 600bps. The blended portfolio fell roughly -2% to -3% (40% of -20% = -8%, plus 60% of +15% = +9%, netting 1%). Still positive, but far below pure Treasuries.

50% Treasuries, 30% IG, 20% HY approach: HY bonds fell 55–60% in 2008. The blended portfolio fell roughly -8% to -10% (20% of -55% = -11%, 30% of -20% = -6%, 50% of +15% = +7.5%, netting -9.5%).

The lesson: in a true financial crisis, IG credit is a meaningful drag on returns, and HY credit is a disaster. But this outcome was rare. Only in 2008, 2020 (brief), and 2011 (European debt crisis) have IG spreads spiked above 250bps. Most years, IG bonds deliver superior returns to Treasuries with minimal risk.

The allocation decision tree​

For most portfolios:

  • Conservative (age 60+, short time horizon): 80% Treasuries, 20% IG credit. Target yield 4.2%.
  • Moderate (age 40–60, medium time horizon): 60% Treasuries, 40% IG credit. Target yield 4.6%.
  • Growth (age 20–40, long time horizon): 40% Treasuries, 50% IG credit, 10% HY credit. Target yield 5.2%.

These allocations assume you have a stable equity allocation that provides equity returns. The bond allocation is for safety and rebalancing fuel, not growth.

If you are building a bond ladder (maturity ladder, not a fund), the safest approach is pure Treasuries. If you are in a core bond fund (BND, AGG), you automatically get a mix of ~30% IG credit and ~70% Treasuries, which is a reasonable default.

Diversification across credit: individual bonds vs funds​

Many investors prefer bond funds (BND, AGG, LQD) because they provide instant diversification and lower costs. But individual bond investors sometimes build ladders:

  • 5 Treasuries: $10k each, maturing years 1–10
  • 5 IG bonds: $10k each, from different issuers (Apple, Microsoft, JPMorgan, Coca-Cola, Procter & Gamble)

This approach gives you control, lower management fees, and known maturity dates. The downside is that you need $100k minimum to be properly diversified, and you must monitor credit quality. If Microsoft's credit rating deteriorates, you can't easily swap it out of a $10k position.

For portfolios under $250k, bond funds (BND, AGG) are easier. For portfolios over $500k, a 70/30 split between a Treasury ladder and an IG bond fund provides both diversification and control.

The yield curve: Treasuries along the curve​

Treasuries vary by maturity: 2-year Treasuries yield roughly 3.8%, 10-years yield 4.0%, and 30-years yield 4.2%. The choice depends on your time horizon and interest rate expectations.

A conservative investor near retirement should own short-duration Treasuries (SHV, 1–3 year ladder) because they don't lose value if rates spike. A young investor with decades until retirement can own long-duration Treasuries (TLT, 10–30 year ladder) to capture potential gains if rates fall.

IG credit bonds are less sensitive to maturity because the credit spread is the dominant source of return. A 5-year IG bond and a 10-year IG bond both yield roughly 5.2%, so the choice is less about capturing rate moves and more about reinvestment risk.

Decision flowchart: Treasury vs credit allocation​

Next​

You now understand the credit spectrum—from risk-free Treasuries to speculative high-yield bonds. But within corporate credit, a new decision awaits: what quality level of bonds should you own? The next article explores the difference between investment-grade (blue-chip) bonds and high-yield (speculative) bonds, and how bond quality shapes portfolio behavior during downturns.