Bond risk, bond return volatility, and the term structure of interest rates

This paper explores the time variation in the bond risk, as measured by the covariation of bond returns with stock returns and consumption growth, and in the volatility of bond returns. A robust stylized fact in empirical finance is that the spread between the yields on long- and short-term bonds forecasts future excess returns on bonds at varying horizons positively; in addition, the short-term nominal interest rate forecasts both the stock return volatility and the exchange rate volatility positively. This paper presents evidence that movements in both the short-term nominal interest rate and the yield spread are positively related to changes in the subsequent realized bond risk and bond return volatility. The yield spread appears to proxy for business conditions, while the short rate appears to proxy for inflation and economic uncertainty. A decomposition of bond betas into a real cash flow risk component and a discount rate risk component shows that yield spreads have offsetting effects in each component. A widening yield spread is correlated with a reduced cash-flow (or inflationary) risk for bonds, but it is also correlated with a larger discount rate risk for bonds. The short rate only forecasts the discount rate component of the bond beta.