The volatility of long-term bond returns: Persistent interest shocks and time-varying risk premiums

We develop a model that can match two stylized facts of the term-structure.The first stylized fact is the predictability of excess returns on long-term bonds.Modeling this requires sufficient volatility and persistence in the price of risk. The second stylized fact is that long-term yields are dominated by a level factor, which requires persistence in the spot interest rate. We find that a fractionally integrated process for the short rate plus a fractionally integrated specification for the price of risk leads to an analytically tractable almost affine term structure model that can explain the stylized facts. In a decomposition of long-term bond returns we find that the expectations component from the level factor is more volatile than the returns themselves. It therefore takes a volatile risk premium that is negatively correlated with innovations in the level factor to explain the volatility of long-term bond returns. The model also implies that excess bond returns do not exhibit mean reversion, consistent with the empirical evidence.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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