Bond Return Predictability: Economic Value and Links to the Macroeconomy

Studies of bond return predictability ?nd a puzzling disparity between strong statistical evidence of return predictability and the failure to convert return forecasts into economic gains. We show that resolving this puzzle requires accounting for important features of bond return models such as time varying parameters and volatility dynamics. A three-factor model comprising the Fama and Bliss (1987) forward spread, the Cochrane and Piazzesi (2005) com- bination of forward rates and the Ludvigson and Ng (2009) macro factor generates notable gains in out-of-sample forecast accuracy compared with a model based on the expectations hypothesis. Importantly, we ?nd that such gains in predictive accuracy translate into higher risk-adjusted portfolio returns after accounting for estimation error and model uncertainty, as evidenced by the performance of model combinations. Finally, we ?nd that bond excess returns are predicted to be signi?cantly higher during periods with high in?ation uncertainty and low economic growth and that the degree of predictability rises during recessions.