Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Bond risk premium

• The bond risk premium (BRP) or term premium is the expected return advantage of long-duration government bonds over short-term (one-period) bonds.

• The yield curve reflects both the BRP and the market’s interest rate expectations. Yield curve steepness is a noisy measure of either part. Better BRP proxies try to isolate out unobservable rate expectations from the curve.

• Historical average returns increase with duration, especially at short durations. Realized average excess return is about 1% but is higher during periods when falling yields give unexpected windfall gains.

• Empirically the yield curve has been a better predictor of near-term excess bond returns than of future yield changes. Survey data hint that much of the predictability in the bond market may reflect expectational errors rather than rational BRPs.

• The yield curve is not able to predict multi-year excess bond returns. It may be a poor BRP proxy because mean-reverting rate expectations dominate curve steepness when short-term rates are exceptionally high or low. High inflation and yield levels are not only associated with falling rate expectations but also with elevated bond risk premia. These forces tend to push the curve shape in opposite directions and offset each other. The clearest example of this tension occurred in 1980–1982 when the curve was inverted but the required ex ante BRP was high—as were subsequent realized bond returns in the 1980s.

• Since rate expectations taint information ...