Bond Risk Premia

By John H. Cochrane, Monika Piazzesi. 2005

1,448 citations recorded by the source corpus.

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.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/8551fa58166cc347612a6ca10ac191f2a4634991

How researchers see this paper

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In Economics and Econometrics

1. Kenneth J. Singleton
2. J. Wu
3. Sydney C. Ludvigson
4. Tim Bollerslev
5. V. Todorov
6. James D. Hamilton
7. Jonathan H. Wright
8. Serena Ng

In Finance

1. J. Wu
2. V. Todorov
3. Tim Bollerslev
4. Kenneth J. Singleton
5. Liuren Wu
6. Hao Zhou
7. George Tauchen
8. Pierre Collin-Dufresne

Citations in the corpus

• Optimal Decentralized Investment Management (2008, neutral): “…assume that the investor is uncertain about the 2See, for example, Ang and Bekaert (2005), Lewellen (2004), Campbell and Yogo (2005), and Torous, Valkanov, and Yan (2005) for stock return predictability, and Dai and Singleton (2002) and Cochrane and Piazzesi (2005) for bond return predictability.”
• Monetary Policy, Financial Conditions, and Financial Stability (2014, background): “For example, the time variation in Treasury returns primarily is due to changes in the pricing of risk rather than to changes in expectations of future short rates (see Campbell and Shiller 1984, Cochrane and Piazzesi 2005, and Cochrane 2011).”
• Decomposing real and nominal yield curves (2016, neutral): “Given this set of pricing factors as well as the excess holding period Treasury and TIPS returns, we then estimate the parameters of our model 6Cochrane and Piazzesi (2005, 2008), Duffee (2011), Joslin, Priebsch, and Singleton (2012), Adrian, Crump, and Moench (2013) and others show that factors wit”
• On the Timing and Pricing of Dividends (2011, neutral): “Our paper relates to Lettau and Wachter (2007) and Croce, Lettau, and Ludvigson (2009).”
• Determinants of Bank Interest Margins: Impact of Maturity Transformation (2015, background): “…term spread is the difference between the duration- 12Alternative approaches document the power of current forward rates (Fama and Bliss, 1987), or linear combinations of forward rates (Cochrane and Piazzesi, 2005) to forecast future excess returns for maturities ranging from one to five years.”
• Expected Returns in Treasury Bonds (2015, neutral): “The Cochrane and Piazzesi (2005) result, which we also confirm, suggests that the data is not far away from this benchmark.”
• A Long-Run Risks Explanation of Predictability Puzzles in Bond and Currency Markets (2012, positive): “First, the two uncertainty variables predict about 18% of future excess bond returns, comparable to the amount of predictability based on multiple yield variables, such as the Cochrane and Piazzesi (2005) bond risk premium factor, which is between 15% to 20% in our sample.”
• Fiscal Policy and the Term Structure of Interest Rates (2005, neutral): “By expanding the state space to the companion form 5See Cochrane and Piazzesi (2005) for recent results.”
• The Cross-Section and Time-Series of Stock and Bond Returns (2017, neutral): “See for instance Fama and French (1988), Cochrane (2006), Lettau and Van Nieuwerburgh (2007), and Binsbergen and Koijen (2007).”
• Presidential Address: Discount Rates (2011, background): “As a small step down this road, Cochrane and Piazzesi (2005, 2008) find that forward rates of all maturities help to forecast bond returns of each maturity.”
• Multifactor models and their consistency with the ICAPM (2012, neutral): “For details on the construction of CP, see Cochrane and Piazzesi (2005).”
• Sharpe ratios in term structure models (2010, methodology): “The perceived importance of the final category has grown substantially since the work of Cochrane and Piazzesi (2005).”
• Out-of-Sample Predictions of Bond Excess Returns and Forward Rates: An Asset Allocation Perspective (2010, neutral): “FB, CP and EH denote Fama and Bliss (1987), Cochrane and Piazzesi (2005) and the no predictability benchmark respectively.”
• Information in (and not in) the Term Structure (2011, methodology): “Prior to Cochrane and Piazzesi (2005), this variation was typically captured by linking the price of level risk to the slope of the term structure.”