Bond Risk Premia

TLDR: In this paper, the authors study time-varying risk premia in U.S. government bonds and find that a single factor, a single tent-shaped linear combination of forward rates, predicts excess returns on one- to five-year maturity bonds with R2 up to 0.44.

Abstract: We study time variation in expected excess bond returns. We run regressions of one-year excess returns on initial forward rates. We find that a single factor, a single tent-shaped linear combination of forward rates, predicts excess returns on one- to five-year maturity bonds with R2 up to 0.44. The return-forecasting factor is countercyclical and forecasts stock returns. An important component of the returnforecasting factor is unrelated to the level, slope, and curvature movements described by most term structure models. We document that measurement errors do not affect our central results. (JEL GO, G1, EO, E4) We study time-varying risk premia in U.S. government bonds. We run regressions of oneyear excess returns-borrow at the one-year rate, buy a long-term bond, and sell it in one year- on five forward rates available at the beginning of the period. By focusing on excess returns, we net out inflation and the level of interest rates, so we focus directly on real risk premia in the nominal term structure. We find R2 values as high as 44 percent. The forecasts are statistically significant, even taking into account the small-sample properties of test statistics, and they survive a long list of robustness checks. Most important, the pattern of regression coefficients is the same for all maturities. A single "return-forecasting factor," a single linear combination of forward rates or yields, describes time-variation in the expected return of all bonds.