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Macro Factors in Bond Risk Premia

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  • Sydney C. Ludvigson
  • Serena Ng

Abstract

Are there important cyclical fluctuations in bond market premiums and, if so, with what macroeconomic aggregates do these premiums vary? We use the methodology of dynamic factor analysis for large datasets to investigate possible empirical linkages between forecastable variation in excess bond returns and macroeconomic fundamentals. We find that "real" and "inflation" factors have important forecasting power for future excess returns on U.S. government bonds, above and beyond the predictive power contained in forward rates and yield spreads. This behavior is ruled out by commonly employed affine term structure models where the forecastability of bond returns and bond yields is completely summarized by the cross-section of yields or forward rates. An important implication of these findings is that the cyclical behavior of estimated risk premia in both returns and long-term yields depends importantly on whether the information in macroeconomic factors is included in forecasts of excess bond returns. Without the macro factors, risk premia appear virtually acyclical, whereas with the estimated factors risk premia have a marked countercyclical component, consistent with theories that imply investors must be compensated for risks associated with macroeconomic activity. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Suggested Citation

  • Sydney C. Ludvigson & Serena Ng, 2009. "Macro Factors in Bond Risk Premia," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5027-5067, December.
  • Handle: RePEc:oup:rfinst:v:22:y:2009:i:12:p:5027-5067
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    File URL: http://hdl.handle.net/10.1093/rfs/hhp081
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    References listed on IDEAS

    as
    1. James H. Stock & Mark W. Watson, 2005. "Implications of Dynamic Factor Models for VAR Analysis," NBER Working Papers 11467, National Bureau of Economic Research, Inc.
    2. Stock J.H. & Watson M.W., 2002. "Forecasting Using Principal Components From a Large Number of Predictors," Journal of the American Statistical Association, American Statistical Association, vol. 97, pages 1167-1179, December.
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    More about this item

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E0 - Macroeconomics and Monetary Economics - - General
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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