Working Papers present research work by both Danmarks Nationalbank’s employees and our partners. Working Papers are primarily targeted at professionals and people with an interest in central banking research as well as economics and finance in a broader sense.
Risk and return in the bond markets – past developments and future prospects
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.