Bond Return Predictability: Economic Value and Links to the Macroeconomy

63 Pages Posted: 25 Sep 2014

See all articles by Davide Pettenuzzo

Davide Pettenuzzo

Brandeis University - International Business School

Date Written: August 2014

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 and volatility dynamics. A three-factor model comprising the Fama-Bliss (1987) forward spread, the Cochrane-Piazzesi (2005) combination of forward rates and the Ludvigson-Ng (2009) macro factor generates notable gains in out-of-sample forecast accuracy compared with a model based on the expectations hypothesis. Importantly, we find that 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 model combinations. Finally, we find that bond excess returns are predicted to be significantly higher during periods with high inflation uncertainty and low economic growth and that the degree of predictability rises during recessions.

Keywords: Bayesian estimation, bond returns, model uncertainty, stochastic volatility, time-varying parameters

JEL Classification: G11, G12, G17

Suggested Citation

Pettenuzzo, Davide, Bond Return Predictability: Economic Value and Links to the Macroeconomy (August 2014). CEPR Discussion Paper No. DP10104. Available at SSRN: https://ssrn.com/abstract=2501576

Davide Pettenuzzo (Contact Author)

Brandeis University - International Business School ( email )

Mailstop 32
Waltham, MA 02454-9110
United States

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