Understanding Bond Risk Premia Uncovered by the Term Structure

Abstract

This paper makes a step towards understanding the term-structure forecasts of bond risk premia. Two economically interpretable variables, the level of nominal forward rates, and one-year-ahead expected inflation extracted from the forwards (IE factor) are enough to summarize virtually all of predictive power for excess bond returns contained in the factor of Cochrane and Piazzesi [2005] (CP). The IE is constructed by regressing realized inflation on five forward rates, which improves substantially upon predictive regressions for inflation that use the term spread and the spot rate only. The intuition can be well explained in terms of natural cointegration between nominal level and the IE factor. Deviations from this long-term relation explain 95 percent of the variation in the CP factor, and have clear business cycle properties. Apart from that, they are large around inflationary 70's and 80's, and more moderate in the 50's, 60's, and in the most recent period which includes the financial crisis. This explains weaker predictability of excess bond returns in the subsamples that cover the most recent years.