RFS Advance Access originally published online on October 20, 2009
Review of Financial Studies 2009 22(12):5027-5067; doi:10.1093/rfs/hhp081
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Macro Factors in Bond Risk Premia
New York University and NBER
Columbia University
Send correspondence to Sydney C. Ludvigson, Department of Economics, New York University, 19 West 4th Street, 6th Floor, New York, NY 10012; telephone: (212) 998-8927; fax: (212) 995-4186. E-mail: sydney.ludvigson{at}nyu.edu.
JEL Classification: E0, E4, G10, G12
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Abstract |
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Are there important cyclical fluctuations in bond market premiums and, if so, with what macroeconomic aggregates do these premiums vary? We use the methodology of dynamic factor analysis for large datasets to investigate possible empirical linkages between forecastable variation in excess bond returns and macroeconomic fundamentals. We find that "real" and "inflation" factors have important forecasting power for future excess returns on U.S. government bonds, above and beyond the predictive power contained in forward rates and yield spreads. This behavior is ruled out by commonly employed affine term structure models where the forecastability of bond returns and bond yields is completely summarized by the cross-section of yields or forward rates. An important implication of these findings is that the cyclical behavior of estimated risk premia in both returns and long-term yields depends importantly on whether the information in macroeconomic factors is included in forecasts of excess bond returns. Without the macro factors, risk premia appear virtually acyclical, whereas with the estimated factors risk premia have a marked countercyclical component, consistent with theories that imply investors must be compensated for risks associated with macroeconomic activity.
This material is based upon work supported by the National Science Foundation under Grant No. 0617858 to Ludvigson and Grant SES 0549978 to Ng. Ludvigson also acknowledges financial support from the Alfred P. Sloan Foundation and the CV Starr Center at NYU. We thank Dave Backus, Mikhail Chernov, Todd Clark, Greg Duffee, Pierre Collin-Dufresne, Mark Gertler, Kenneth Kuttner, John Leahy, Monika Piazzesi, Glenn Rudebusch, and Jonathan Wright; as well as seminar participants at Indiana University, the New York Area Monetary Policy Workshop, November 2006, and the Vienna Symposium on Asset Management, July 2007, for helpful comments. We are also grateful to Monika Piazzesi for help with the bond data, and to Mark Watson for help with the macro data. Jaewon Choi, Bernadino Palazzo, and Matt Smith provided excellent research assistance.