When Can Life-Cycle Investors Benefit from Time-Varying Bond Risk Premia?

Abstract:     
We study the economic importance of time-varying bond risk premia in a life-cycle consumption and portfolio-choice problem for an investor facing short-sales and borrowing constraints. On average, the investor is able to time bond markets only as of age~45. Tilts in the optimal asset allocation in response to changes in bond risk premia exhibit pronounced life-cycle patterns. Taking as a point of reference an investor who conditions only on age and wealth, we compute the management fee this investor is willing to pay to account for either current risk premia or for both current and future risk premia. We find the fees to account for current risk premia to be economically sizeable, ranging up to 1\% per annum, but this fee is comparable to the fee of the fully optimal strategy. To solve our model, we extend recently developed simulation-based techniques to life-cycle problems featuring multiple state variables and multiple risky assets.

Number of Pages in PDF File: 49

Keywords: bond risk premia, life-cycle consumption, portfolio choice

JEL Classification: D91, E43, G11, G12

working papers series