A Beta Based Framework for (Lower) Bond Risk Premia

Abstract

We use a no-arbitrage essentially affine three-factor model to estimate term premia in US and German ten-year government bond yields. In line with the existing literature, we find that estimated premia have followed a downward trend since the 1980s: from 4.9 per cent in 1981 to 0.7 per cent in 2006 for the US bond and from 3.3 to 0.5 per cent for the German one. Subsequently, using an Error Correction Model (ECM) we prove that the decline is explained by a decrease in global output variability and an increase in the power of ten-year government bonds to diversify the investors' portfolios. In addition, the ECM also forecasts both the US and the German term premia converging to around one percentage point over a five year horizon. Long-term return expectations for ten-year government bonds will have to incorporate bond risk premia that - while in line with average excess returns during the twentieth century - are significantly lower than average excess returns over the last two decades.

Keywords: Term structure model, bond risk premium, modern portfolio theory

JEL Classification: C13, C14, E43, E47, G12, G15