Bond Return Predictability: Economic Value and Links to the Macroeconomy

68 Pages Posted: 26 Jul 2014 Last revised: 5 Jun 2017

See all articles by Antonio Gargano

Antonio Gargano

University of Melbourne - Department of Finance

Davide Pettenuzzo

Brandeis University - International Business School

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Date Written: April 10, 2017

Abstract

Studies of bond return predictability find a puzzling disparity between strong statistical evidence of return predictability and the failure to convert return forecasts into economic gains. We show that resolving this puzzle requires accounting for important features of bond return models such as time varying parameters, volatility dynamics, and unspanned macro factors. A three-factor model comprising the Fama and Bliss (1987) forward spread, the Cochrane and Piazzesi (2005) combination of forward rates and the Ludvigson and Ng (2009) macro factor generates notable gains in out-of-sample forecast accuracy compared with a model based on the expectations hypothesis. Such gains in predictive accuracy translate into higher risk-adjusted portfolio returns after accounting for estimation error and model uncertainty, as evidenced by the performance of forecast combinations. Consistent with models featuring unspanned macro factors, our forecasts of future bond excess returns are strongly negatively correlated with survey forecasts of short rates.

Keywords: bond returns, yield curve, macro factors, stochastic volatility, time-varying parameters, unspanned macro risk factors

JEL Classification: G11, G12, G17

Suggested Citation

Gargano, Antonio and Pettenuzzo, Davide and Timmermann, Allan, Bond Return Predictability: Economic Value and Links to the Macroeconomy (April 10, 2017). Available at SSRN: https://ssrn.com/abstract=2471273 or http://dx.doi.org/10.2139/ssrn.2471273

Antonio Gargano

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 3010
Australia

Davide Pettenuzzo (Contact Author)

Brandeis University - International Business School ( email )

Mailstop 32
Waltham, MA 02454-9110
United States

Allan Timmermann

UCSD ( email )

9500 Gilman Drive
La Jolla, CA 92093-0553
United States
858-534-0894 (Phone)

HOME PAGE: http://rady.ucsd.edu/people/faculty/timmermann/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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