Working Paper: NBER ID: w9178
Authors: John H. Cochrane; Monika Piazzesi
Abstract: This paper studies time variation in expected excess bond returns. We run regressions of annual excess returns on forward rates. We find that a single factor predicts 1-year excess returns on 1-5 year maturity bonds with an R2 up to 43%. The single factor is a tent-shaped linear function of forward rates. The return forecasting factor has a clear business cycle correlation: Expected returns are high in bad times, and low in good times, and the return-forecasting factor forecasts long-run output growth. The return-forecasting factor also forecasts stock returns, suggesting a common time-varying premium for real interest rate risk. The return forecasting factor is poorly related to level, slope, and curvature movements in bond yields. Therefore, it represents a source of yield curve movement not captured by most term structure models. Though the return-forecasting factor accounts for more than 99% of the time-variation in expected excess bond returns, we find additional, very small factors that forecast equally small differences between long term bond returns, and hence statistically reject a one-factor model for expected returns.
Keywords: bond risk premia; expected excess returns; forward rates; business cycles; term structure
JEL Codes: G1; E4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| return forecasting factor (G17) | expected excess bond returns (G12) |
| return forecasting factor (G17) | long-run output growth (O40) |
| return forecasting factor (G17) | stock returns (G12) |
| business cycle conditions (E32) | expected excess bond returns (G12) |
| return forecasting factor (G17) | yield curve variation (E43) |
| return forecasting factor (G17) | idiosyncratic movements in bond prices (E43) |