Bond Return Predictability: Economic Value and Links to the Macroeconomy

Studies of bond return predictability find a puzzling disparity between strong statistical evidence of return predictability and the failure to convert return forecasts into economic gains. We show that resolving this puzzle requires accounting for important features of bond return models such as time varying parameters, volatility dynamics, and unspanned macro factors. A three-factor model comprising the Fama and Bliss (1987) forward spread, the Cochrane and Piazzesi (2005) combination of forward rates and the Ludvigson and Ng (2009) macro factor generates notable gains in out-of-sample forecast accuracy compared with a model based on the expectations hypothesis. Such gains in predictive accuracy translate into higher risk-adjusted portfolio returns after accounting for estimation error and model uncertainty. Consistent with models featuring unspanned macro factors, our forecasts of future bond excess returns are strongly negatively correlated with survey forecasts of short rates.