Economic-State Variation in the Post-1997 Relation between Equity Risk and T-bond Returns
58 Pages Posted: 20 Nov 2014 Last revised: 16 Jul 2018
Date Written: November 15, 2017
Abstract
Recent literature suggests an elevated hedging influence in T-bond pricing since the late 1990’s. Over 1997 to 2013, we find that the relation between T-bond pricing and equity risk has a strong economic-state contingency, one that supports and further qualifies the hedge premise over this period. Specifically, using a dual-risk framework with equity-index and T-bond implied volatilities, we find that the partial relation between T-bond returns and concurrent equity-risk innovations is several times stronger over a `late recession/early uncertain recovery' (LRER) segment of the economic cycle. LRER segments feature an elevated equity variance-risk premium, weak economic conditions, and lower consumer sentiment; characteristics suggestive of higher risk aversion. Intertemporally, also consistent with this hedge premise, we find that the partial predictive relation between equity-risk levels and subsequent T-bond excess returns is reliably negative over the economic cycles suggested by our LRER segments. Controlling for T-bond risk is important in establishing these findings.
Keywords: Equity risk, bond risk, Treasury bond returns, bond risk premia, hedging, risk aversion, economic states.
JEL Classification: G12
Suggested Citation: Suggested Citation