Risk and return in the bond markets – past developments and future prospects
Working paper no 40, 2006
The paper examines the past risk and return trade-off on the US bond market, anduses this as a basis for developing a flexible tool based on simulation of principalcomponents to evaluate future prospects for risk and returns for investors. Theprincipal components of the yield curve are related to a few main macro-economicdrivers (inflation and real GDP-gap). This allows simulation of yields curves basedon expectations about the future behaviour of the macro-economic drivers, ratherthan relying solely on parameters estimated from historic data. The overallconclusion is that since 1960 the US-bond market has rewarded risk in the sensethat more volatile bond returns has been associated with higher average realizedreturns. However, this covers very large variation over sub-periods, and in periodswith increasing yield trend extra risk has not always been rewarded. In thesimulations of the future risk-return trade-off, there are lower excess returns fromenhancing the duration exposure in the future relative to the near past. However,the risk associated with duration enhancing is also lower.