Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds

44 Pages Posted: 20 Mar 2008 Last revised: 15 Jan 2013

See all articles by John Y. Campbell

John Y. Campbell

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Adi Sunderam

Harvard Business School

Luis M. Viceira

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: January 15, 2013

Abstract

The covariance between US Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953-2009, it was unusually high in the early 1980’s and negative in the 2000’s, particularly in the downturns of 2000-02 and 2007-09. This paper species and estimates a model in which the nominal term structure of interest rates is driven by four state variables: the real interest rate, temporary and permanent components of expected inflation, and the “nominal-real covariance” of inflation and the real interest rate with the real economy. The last of these state variables enables the model to fit the changing covariance of bond and stock returns. Log bond yields and term premia are quadratic in these state variables, with term premia determined by the nominal-real covariance. The concavity of the yield curve ― the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields ― is a good proxy for the level of term premia. The nominal-real covariance has declined since the early 1980’s, driving down term premia.

Keywords: Term structure of interest rates, inflation risk, time varying expected returns, bond return predictability, expectations hypothesis, macro asset pricing

JEL Classification: G12

Suggested Citation

Campbell, John Y. and Sunderam, Adi and Viceira, Luis M., Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds (January 15, 2013). AFA 2009 San Francisco Meetings Paper; Harvard Business School Finance Working Paper No. 09-088. Available at SSRN: https://ssrn.com/abstract=1108301 or http://dx.doi.org/10.2139/ssrn.1108301

John Y. Campbell

Harvard University - Department of Economics ( email )

Littauer Center
Room 213
Cambridge, MA 02138
United States
617-496-6448 (Phone)
617-495-7730 (Fax)

HOME PAGE: http://scholar.harvard.edu/campbell

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Adi Sunderam

Harvard Business School ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

Luis M. Viceira (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6331 (Phone)
617-496-6592 (Fax)

HOME PAGE: http://www.people.hbs.edu/lviceira

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
882
Abstract Views
3,554
rank
22,623
PlumX Metrics