IDEAS home Printed from https://ideas.repec.org/p/red/sed012/771.html
   My bibliography  Save this paper

Understanding bond risk premia

Author

Listed:
  • Pavol Povala

    (University of Lugano)

  • Anna Cieslak

    (Northwestern University)

Abstract

We decompose yields into long-horizon expected inflation and maturity-related cycles to study the predictability of bond excess returns. Cycles capture the risk premium and the business cycle variation of short rate expectations. From cycles, we construct a forecasting factor that explains up to above 50% (30%) of in-sample (out-of-sample) variation of annual bond returns. The factor varies at a frequency higher than the business cycle, and predicts real activity at long horizons. It also aggregates information from different macro-finance predictors of bond returns. Our decomposition reveals why bond returns are predictable by a linear combination of forward rates or the term spread.

Suggested Citation

  • Pavol Povala & Anna Cieslak, 2012. "Understanding bond risk premia," 2012 Meeting Papers 771, Society for Economic Dynamics.
    • Handle: RePEc:red:sed012:771
    as

    Download full text from publisher

    File URL: https://red-files-public.s3.amazonaws.com/meetpapers/2012/paper_771.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Jardet, Caroline & Monfort, Alain & Pegoraro, Fulvio, 2013. "No-arbitrage Near-Cointegrated VAR(p) term structure models, term premia and GDP growth," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 389-402.
    2. Ivo Welch & Amit Goyal, 2008. "A Comprehensive Look at The Empirical Performance of Equity Premium Prediction," The Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1455-1508, July.
    3. John Y. Campbell & Pierre Perron, 1991. "Pitfalls and Opportunities: What Macroeconomists Should Know about Unit Roots," NBER Chapters, in: NBER Macroeconomics Annual 1991, Volume 6, pages 141-220, National Bureau of Economic Research, Inc.
    4. Ilan Cooper, 2009. "Time-Varying Risk Premiums and the Output Gap," The Review of Financial Studies, Society for Financial Studies, vol. 22(7), pages 2601-2633, July.
    5. Clark, Todd E. & McCracken, Michael W., 2001. "Tests of equal forecast accuracy and encompassing for nested models," Journal of Econometrics, Elsevier, vol. 105(1), pages 85-110, November.
    6. Jean-Sébastien Fontaine & René Garcia, 2012. "Bond Liquidity Premia," The Review of Financial Studies, Society for Financial Studies, vol. 25(4), pages 1207-1254.
    7. Croushore, Dean & Stark, Tom, 2001. "A real-time data set for macroeconomists," Journal of Econometrics, Elsevier, vol. 105(1), pages 111-130, November.
    8. Andrew Ang & Geert Bekaert, 2007. "Stock Return Predictability: Is it There?," The Review of Financial Studies, Society for Financial Studies, vol. 20(3), pages 651-707.
    9. Carceles-Poveda, Eva & Giannitsarou, Chryssi, 2007. "Adaptive learning in practice," Journal of Economic Dynamics and Control, Elsevier, vol. 31(8), pages 2659-2697, August.
    10. Glenn D. Rudebusch & Tao Wu, 2008. "A Macro‐Finance Model of the Term Structure, Monetary Policy and the Economy," Economic Journal, Royal Economic Society, vol. 118(530), pages 906-926, July.
    11. Dewachter, Hans & Iania, Leonardo, 2011. "An Extended Macro-Finance Model with Financial Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(6), pages 1893-1916, December.
    12. Jonathan A. Parker & Christian Julliard, 2005. "Consumption Risk and the Cross Section of Expected Returns," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 185-222, February.
    13. John H. Cochrane & Monika Piazzesi, 2005. "Bond Risk Premia," American Economic Review, American Economic Association, vol. 95(1), pages 138-160, March.
    14. Kozicki, Sharon & Tinsley, P A, 1998. "Moving Endpoints and the Internal Consistency of Agents' Ex Ante Forecasts," Computational Economics, Springer;Society for Computational Economics, vol. 11(1-2), pages 21-40, April.
    15. Dean Croushore, 2019. "Revisions to PCE Inflation Measures: Implications for Monetary Policy," International Journal of Central Banking, International Journal of Central Banking, vol. 15(4), pages 241-265, October.
    16. Hans Dewachter & Marco Lyrio, 2008. "Learning, Macroeconomic Dynamics and the Term Structure of Interest Rates," NBER Chapters, in: Asset Prices and Monetary Policy, pages 191-245, National Bureau of Economic Research, Inc.
    17. Engle, Robert & Granger, Clive, 2015. "Co-integration and error correction: Representation, estimation, and testing," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 39(3), pages 106-135.
    18. Sydney C. Ludvigson & Serena Ng, 2009. "Macro Factors in Bond Risk Premia," The Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5027-5067, December.
    19. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," The Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-386.
    20. John Y. Campbell & Samuel B. Thompson, 2008. "Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average?," The Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1509-1531, July.
    21. John Y. Campbell & Robert J. Shiller, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 58(3), pages 495-514.
    22. Eugene F. Fama, 2006. "The Behavior of Interest Rates," The Review of Financial Studies, Society for Financial Studies, vol. 19(2), pages 359-379.
    23. Robert B. Barsky & J. Bradford De Long, 1991. "Forecasting Pre-World War I Inflation: The Fisher Effect and the Gold Standard," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 106(3), pages 815-836.
    24. James H. Stock & Mark W. Watson, 2007. "Why Has U.S. Inflation Become Harder to Forecast?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(s1), pages 3-33, February.
    25. Estrella, Arturo & Hardouvelis, Gikas A, 1991. "The Term Structure as a Predictor of Real Economic Activity," Journal of Finance, American Finance Association, vol. 46(2), pages 555-576, June.
    26. George W. Evans & Seppo Honkapohja, 2009. "Learning and Macroeconomics," Annual Review of Economics, Annual Reviews, vol. 1(1), pages 421-451, May.
    27. Gregory R. Duffee, 2011. "Information in (and not in) the Term Structure," The Review of Financial Studies, Society for Financial Studies, vol. 24(9), pages 2895-2934.
    28. William J. Crowder & Mark E. Wohar, 1999. "Are Tax Effects Important in the Long‐Run Fisher Relationship? Evidence from the Municipal Bond Market," Journal of Finance, American Finance Association, vol. 54(1), pages 307-317, February.
    29. John A. Carlson, 1977. "A Study of Price Forecasts," NBER Chapters, in: Annals of Economic and Social Measurement, Volume 6, number 1, pages 27-56, National Bureau of Economic Research, Inc.
    30. Robert Mundell, 1963. "Inflation and Real Interest," Journal of Political Economy, University of Chicago Press, vol. 71(3), pages 280-280.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Kees E. Bouwman & Elvira Sojli & Wing Wah Tham, 2012. "Aggregate Stock Market Illiquidity and Bond Risk Premia," Tinbergen Institute Discussion Papers 12-140/IV/DSF46, Tinbergen Institute.
    2. Shin, Minchul & Zhong, Molin, 2017. "Does realized volatility help bond yield density prediction?," International Journal of Forecasting, Elsevier, vol. 33(2), pages 373-389.
    3. Dockner, Engelbert J. & Mayer, Manuel & Zechner, Josef, 2013. "Sovereign bond risk premiums," CFS Working Paper Series 2013/28, Center for Financial Studies (CFS).
    4. Duffee, Gregory, 2013. "Forecasting Interest Rates," Handbook of Economic Forecasting, in: G. Elliott & C. Granger & A. Timmermann (ed.), Handbook of Economic Forecasting, edition 1, volume 2, chapter 0, pages 385-426, Elsevier.
    5. Michael D. Bauer & Glenn D. Rudebusch, 2017. "Resolving the Spanning Puzzle in Macro-Finance Term Structure Models," Review of Finance, European Finance Association, vol. 21(2), pages 511-553.
    6. Dick Dijk & Siem Jan Koopman & Michel Wel & Jonathan H. Wright, 2014. "Forecasting interest rates with shifting endpoints," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 29(5), pages 693-712, August.
    7. Hou, Keqiang & Li, Xing & Li, Zeguang & Wu, Ting, 2021. "Forecasting bond returns in a macro model," International Review of Economics & Finance, Elsevier, vol. 72(C), pages 524-545.
    8. Emanuel Kopp & Peter D. Williams, 2018. "A Macroeconomic Approach to the Term Premium," IMF Working Papers 2018/140, International Monetary Fund.
    9. Philippe Mueller & Andrea Vedolin & Hao Zhou, 2011. "Short Run Bond Risk Premia," FMG Discussion Papers dp686, Financial Markets Group.
    10. Andrea Ajello & Luca Benzoni & Olena Chyruk & Stijn Van Nieuwerburgh, 2020. "Core and ‘Crust’: Consumer Prices and the Term Structure of Interest Rates," The Review of Financial Studies, Society for Financial Studies, vol. 33(8), pages 3719-3765.
    11. Riccardo Rebonato, 2017. "Affine Models With Stochastic Market Price Of Risk," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(04), pages 1-38, June.
    12. Bruno Feunou & Jean-Sébastien Fontaine & Anh Le & Christian Lundblad, 2022. "Tractable Term Structure Models," Management Science, INFORMS, vol. 68(11), pages 8411-8429, November.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Zhang, Han & Guo, Bin & Liu, Lanbiao, 2022. "The time-varying bond risk premia in China," Journal of Empirical Finance, Elsevier, vol. 65(C), pages 51-76.
    2. Doshi, Hitesh & Jacobs, Kris & Liu, Rui, 2018. "Macroeconomic determinants of the term structure: Long-run and short-run dynamics," Journal of Empirical Finance, Elsevier, vol. 48(C), pages 99-122.
    3. Michael D. Bauer & Glenn D. Rudebusch, 2020. "Interest Rates under Falling Stars," American Economic Review, American Economic Association, vol. 110(5), pages 1316-1354, May.
    4. Richard K. Crump & Stefano Eusepi & Emanuel Moench, 2016. "The term structure of expectations and bond yields," Staff Reports 775, Federal Reserve Bank of New York.
    5. Qi Liu & Libin Tao & Weixing Wu & Jianfeng Yu, 2017. "Short- and Long-Run Business Conditions and Expected Returns," Management Science, INFORMS, vol. 63(12), pages 4137-4157, December.
    6. Jing-Zhi Huang & Zhan Shi, 2023. "Machine-Learning-Based Return Predictors and the Spanning Controversy in Macro-Finance," Management Science, INFORMS, vol. 69(3), pages 1780-1804, March.
    7. P. Byrne, Joseph & Cao, Shuo & Korobilis, Dimitris, 2015. "Term Structure Dynamics, Macro-Finance Factors and Model Uncertainty," SIRE Discussion Papers 2015-71, Scottish Institute for Research in Economics (SIRE).
    8. Guo, Bin & Huang, Fuzhe & Li, Kai, 2022. "Time to build and bond risk premia," Journal of Economic Dynamics and Control, Elsevier, vol. 136(C).
    9. Zhang, Han & Fan, Xiaoyun & Guo, Bin & Zhang, Wei, 2019. "Reexamining time-varying bond risk premia in the post-financial crisis era," Journal of Economic Dynamics and Control, Elsevier, vol. 109(C).
    10. Michael D. Bauer & James D. Hamilton, 2018. "Robust Bond Risk Premia," The Review of Financial Studies, Society for Financial Studies, vol. 31(2), pages 399-448.
    11. Duffee, Gregory R., 2013. "Bond Pricing and the Macroeconomy," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 907-967, Elsevier.
    12. Bulkley, George & Harris, Richard D.F. & Nawosah, Vivekanand, 2015. "Can behavioral biases explain the rejections of the expectation hypothesis of the term structure of interest rates?," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 179-193.
    13. Carlo A. Favero & Arie E. Gozluklu & Haoxi Yang, 2016. "Demographics and the Behavior of Interest Rates," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 732-776, November.
    14. Daniel Borup & Jonas N. Eriksen & Mads M. Kjær & Martin Thyrsgaard, 2020. "Predicting bond return predictability," CREATES Research Papers 2020-09, Department of Economics and Business Economics, Aarhus University.
    15. Bakshi, Gurdip & Panayotov, George & Skoulakis, Georgios, 2011. "Improving the predictability of real economic activity and asset returns with forward variances inferred from option portfolios," Journal of Financial Economics, Elsevier, vol. 100(3), pages 475-495, June.
    16. Biao Guo & Hai Lin, 2020. "Volatility and jump risk in option returns," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(11), pages 1767-1792, November.
    17. Ang, Andrew & Piazzesi, Monika & Wei, Min, 2006. "What does the yield curve tell us about GDP growth?," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 359-403.
    18. Dladla, Pholile & Malikane, Christopher, 2019. "Stock return predictability: Evidence from a structural model," International Review of Economics & Finance, Elsevier, vol. 59(C), pages 412-424.
    19. Carlo Altavilla & Raffaella Giacomini & Riccardo Costantini, 2014. "Bond Returns and Market Expectations," Journal of Financial Econometrics, Oxford University Press, vol. 12(4), pages 708-729.
    20. Valentin Haddad & David Sraer, 2020. "The Banking View of Bond Risk Premia," Journal of Finance, American Finance Association, vol. 75(5), pages 2465-2502, October.

    More about this item

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:red:sed012:771. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Christian Zimmermann (email available below). General contact details of provider: https://edirc.repec.org/data/sedddea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.