When can life-cycle investors benefit from time-varying bond risk premia
We study the consumption and investment problem of a life-cycle investor who allocates wealth to equity and bond markets. Consistent with recent empirical evidence, we accommodate time-variation in bond risk premia. Life-cycle investors typically have to comply with borrowing, short-sales, and liquidity constraints. These constraints interfere with the dynamic strategies designed to benefit from time-variation in bond risk premia. We show in particular that the extent to which these constraints restrict such strategies depends on the prevailing bond risk premia, the investor’s age, and the returns that realized to date. The individual will (on average) only be able to time bond markets as of age 45. Further, tilts in the optimal assetallocation in response to changes in bond risk premia are monotonically increasing over the life-cycle for long-term bonds and cash, yet hump-shaped for equity. Finally, we show that the economic gains realized by bond timing strategies peak around age 50 at 0.80% of certainty equivalent consumption and are hump-shaped over the life-cycle. The additional gains realized by implementing hedging strategies turn out to be negligible.