Bond Risk, Bond Return Volatility, and the Term Structure of Interest Rates

56 Pages Posted: 3 May 2007

See all articles by Luis M. Viceira

Luis M. Viceira

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

Date Written: May 2007

Abstract

This paper explores time variation in bond risk, as measured by the covariation of bond returns with stock returns and with consumption growth, and in the volatility of bond returns. A robust stylized fact in empirical finance is that the spread between the yield on long-term bonds and short-term bonds forecasts positively future excess returns on bonds at varying horizons, and that the short-term nominal interest rate forecasts positively stock return volatility and exchange rate volatility. This paper presents evidence that movements in both the short-term nominal interest rate and the yield spread are positively related to changes in subsequent realized bond risk and bond return volatility. The yield spread appears to proxy for business conditions, while the short rate appears to proxy for inflation and economic uncertainty. A decomposition of bond betas into a real cash flow risk component, and a discount rate risk component shows that yield spreads have offsetting effects in each component. A widening yield spread is correlated with reduced cash-flow (or inflationary) risk for bonds, but it is also correlated with larger discount rate risk for bonds. The short rate forecasts only the discount rate component of bond.

JEL Classification: G12

Suggested Citation

Viceira, Luis M., Bond Risk, Bond Return Volatility, and the Term Structure of Interest Rates (May 2007). HBS Finance Working Paper No. 07-082. Available at SSRN: https://ssrn.com/abstract=983950 or http://dx.doi.org/10.2139/ssrn.983950

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

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