Fixed Income

Forecasting U.S. Bond Returns

Topics - Fixed Income

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Forecasting U.S. Bond Returns

It is difficult to forecast bond market fluctuations, although some research shows that these fluctuations are not fully unpredictable: It is possible to identify in advance periods when the reward for duration extension is likely to be abnormally high or abnormally low.

In this article, we first describe a few variables that have the ability to predict near-term bond market performance. We then show how to combine the information that these predictors provide into a single forecast and, further, into implementable investment strategies. Finally, we back-test the historical performance of these strategies in a realistic out-of-sample setting.

We show elsewhere that intermediate- and long-term bonds earn higher average returns than short-term bonds. This evidence suggests that the long-run bond risk premium is positive. If the risk premium is constant over time, the long-run average risk premium is also our best forecast for the near-term bond market performance.

Steeply upward-sloping yield curves tend to precede high excess bond returns, and inverted yield curves tend to precede negative excess bond returns. It follows then that the risk premium is not constant, and that the current shape of the yield curve provides valuable information about the time-varying bond risk premium. In this article, we show that other variables can enhance the yield curve’s ability to forecast near-term excess bond returns.

The predictability of excess bond returns has important implications for investors who are willing to use so-called tactical asset allocation strategies.

Published in

The Journal of Fixed Income

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This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. 

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.