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Inflation Bets Or Deflation Hedges? the Changing Risks of Nominal

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Inflation Bets Or Deflation Hedges? the Changing Risks of Nominal Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds John Y. Campbell, Adi Sunderam, and Luis M. Viceira1 First draft: June 2007 This version: July 22, 2010 1Campbell: Department of Economics, Littauer Center, Harvard University, Cambridge MA 02138, USA, and NBER. Email [email protected]. Sunderam: Harvard Business School, Boston MA 02163. Email [email protected]. Viceira: Harvard Business School, Boston MA 02163 and NBER. Email [email protected]. We acknowledge the extraordinarily able research assistance of Johnny Kang. We are grateful to Geert Bekaert, Andrea Buraschi, Jesus Fernandez-Villaverde, Wayne Ferson, Javier Gil-Bazo, Pablo Guerron, John Heaton, Ravi Jagannathan, Jon Lewellen, Monika Piazzesi, Pedro Santa-Clara, George Tauchen, and seminar participants at the 2009 Annual Meeting of the American Finance Association, Bank of England, European Group of Risk and Insurance Economists 2008 Meeting, Sixth Annual EmpiricalAssetPricingRetreatattheUniversity of Amsterdam Business School, Harvard Business School Finance Unit Research Retreat, Imperial College, Marshall School of Business, NBER Fall 2008 Asset Pricing Meeting, Norges Bank, Society for Economic Dynamics 2008 Meeting, Stockholm School of Economics, Tilburg University, Tuck Business School, and Universidad Carlos III in Madrid for hepful comments and suggestions. This material is based upon work supported by the National Science Foundation under Grant No. 0214061 to Campbell, and by Harvard Business School Research Funding. It was also supported by the U.S. Social Security Administration through Grant No. 10-M-98363-1-02 to the National Bureau of Economic Research as part of the SSA Retirement Research Consortium. The findings and conclusions expressed are solely those of the authors and do not represent the views of SSA, any agency of the Federal Government, or the NBER. Abstract The covariance between US Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953– 2009, it was unusually high in the early 1980’sand negative in the 2000’s, particularly in the downturns of 2001–2and 2008–9. This paper speci…es and estimates a model in which the nominal term structure of interest rates is driven by …ve state variables: the real interest rate, risk aversion, temporary and permanent components of expected in‡ation, and the “nominal-real covariance” of in‡ation and the real interest rate with the real economy. The last of these state variables enables the model to …t the changing covariance of bond and stock returns. Log bond yields and term premia are quadratic in these state variables, with term premia determined mainly by the product of risk aversion and the nominal-real covariance. The concavity of the yield curve— the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields— is a good proxy for the level of term premia. The nominal-real covariance has declined since the early 1980’s, driving down term premia. 1 Introduction Are nominal government bonds risky investments, which investors must be rewarded to hold? Or are they safe investments, whose price movements are either inconse- quential or even bene…cial to investors as hedges against other risks? US Treasury bonds performed well as hedges during the …nancial crisis of 2008–9, but the opposite was true in the early 1980’s. The purpose of this paper is to explore such changes over time in the risks of nominal government bonds. To understand the phenomenon of interest, consider Figure 1, an update of a similar …gure in Viceira (2010). The …gure shows the history of the realized beta of 10-year nominal zero-coupon Treasury bonds on an aggregate stock index, calculated using a rolling three-month window of daily data. This beta can also be called the “realized CAPM beta”, as its forecast value would be used to calculate the risk premium on Treasury bonds in the Capital Asset Pricing Model (CAPM) that is often used to price individual stocks. Figure 1 displays considerable high-frequency variation, much of which is attribut- able to noise in the realized beta. But it also shows interesting low-frequency move- ments, with values close to zero in the mid-1960’sand mid-1970’s, much higher values averaging around 0.4 in the 1980’s, a spike in the mid-1990’s, and negative average values in the 2000’s. During the two downturns of 2001–3 and 2008–9, the average realized beta of Treasury bonds was about -0.2. These movements are large enough to cause substantial changes in the risk premium on Treasury bonds that would be implied by the CAPM. Nominal bond returns respond both to in‡ation and to real interest rates. A natural question is whether the pattern shown in Figure 1 is due to the changing beta of in‡ation with the stock market, or of real interest rates with the stock mar- ket. Figure 2 summarizes the comovement of in‡ation shocks with stock returns, using a rolling three-year window of quarterly data and a …rst-order quarterly vector autoregression for in‡ation, stock returns, and the three-month Treasury bill yield to calculate in‡ation shocks. Because in‡ation is associated with high bond yields and low bond returns, the …gure shows the beta of realized de‡ation shocks (the negative of in‡ation shocks) which should move in the same manner as the bond return beta reported in Figure 1. Indeed, Figure 2 shows a similar history for the de‡ation beta as for the nominal bond beta. 1 There is also movement over time in the covariation of long-term real interest rates with the stock market. In the period since 1997, when long-term Treasury in‡ation-protected securities (TIPS) were …rst issued, Campbell, Shiller, and Viceira (2009) report that TIPS have had a predominantly negative beta with stocks. Like the nominal bond beta, the TIPS beta was particularly negative in the downturns of 2001–3 and 2008–9. This implies that to explain the time-varying risks of nominal bonds, one needs a model that allows changes over time in the covariances of both in‡ation and real interest rates with the real economy and the stock market. In this paper we specify and estimate such a model. Our model allows the covariances of shocks to change over time and potentially switch sign. By specifying stochastic processes for the real interest rate, temporary and permanent components of expected in‡ation, investor risk aversion, and the covariance of in‡ation and the real interest rate with the real economy, we can solve for the complete term structure at each point in time and understand the way in which bond market risks have evolved. We …nd that the covariance of in‡ation and the real interest rate with the real economy is a key state variable whose movements account for the changing covariance of bonds with stocks and imply that bond risk premia have been much lower in recent years than they were in the early 1980’s. The organization of the paper is as follows. Section 2 reviews the related litera- ture. Section 3 presents our model of the real and nominal term structures of interest rates. Section 4 describes our estimation method and presents parameter estimates and historical …tted values for the unobservable state variables of the model. Section 5 discusses the implications of the model for the shape of the yield curve and the movements of risk premia on nominal bonds. Section 6 concludes. An Appendix to this paper available online (Campbell, Sunderam, and Viceira 2010) presents details of the model solution and additional empirical results. 2 Literature Review Nominal bond risks can be measured in a number of ways. A …rst approach is to measure the covariance of nominal bond returns with some measure of the marginal utility of investors. According to the Capital Asset Pricing Model (CAPM), for example, marginal utility can be summarized by the level of aggregate wealth. It follows that the risk of bonds can be measured by the covariance of bond returns with 2 returns on the market portfolio, often proxied by a broad stock index. Alternatively, the consumption CAPM implies that marginal utility can be summarized by the level of aggregate consumption, so the risk of bonds can be measured by the covariance of bond returns with aggregate consumption growth. A second approach is to measure the risk premium on nominal bonds, either from average realized excess bond returns or from variables that predict excess bond returns such as the yield spread (Shiller, Campbell, and Schoenholtz 1983, Fama and Bliss 1987, Campbell and Shiller 1991) or a more general linear combination of forward rates (Stambaugh 1988, Cochrane and Piazzesi 2005). If the risk premium is large, then presumably investors regard bonds as risky. This approach can be combined with the …rst one by estimating an empirical multifactor model that describes the cross-section of both stock and bond returns (Fama and French 1993). These approaches are appealing because they are straightforward and direct. However, the answers they give depend sensitively on the sample period that is used. The covariance of nominal bond returns with stock returns, for example, is extremely unstable over time and even switches sign (Li 2002, Guidolin and Timmermann 2006, Christiansen and Ranaldo 2007, David and Veronesi 2009, Baele, Bekaert, and In- ghelbrecht 2010, Viceira 2010). In some periods, notably the late 1970’s and early 1980’s, bond and stock returns move closely together, implying that bonds have a high CAPM beta and are relatively risky. In other periods, notably the late 1990’s and the 2000’s, bond and stock returns are negatively correlated, implying that bonds have a negative beta and can be used to hedge shocks to aggregate wealth.
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