The Economic Value of Predicting Bond Risk Premia

Abstract

This paper studies whether the evident statistical predictability of bond risk premia translates into economic gains for investors. We propose a novel estimation strategy for ane term structure models that jointly fits yields and bond excess returns, thereby capturing predictive information otherwise hidden to standard es- timations. The model predicts excess returns with high regressions R^2s and high forecast accuracy but cannot outperform the expectations hypothesis out-of-sample in terms of economic value, showing a general contrast between statistical and economic metrics of forecast evaluation. More specifically, the model mostly gener- ates positive (negative) economic value during times of high (low) macroeconomic uncertainty. Overall, the expectation hypothesis remains a useful benchmark for investment decisions in bond markets, especially in low uncertainty states.

Keywords: term structure of interest rates, expectations hypothesis, affine models, risk premia, statistical predictability, economic value

JEL Classification: E43, G12