Can the excess returns of government bonds be predicted? This is a classic research question in finance academic research circles. Sometimes practitioners, who are often buried in the more exciting parts of the financial markets, tend to forget that government bonds (do they even belong in your portfolio) are a large global asset class, representing a whopping 30% of market capitalizations across asset classes ( Doeswijk, Lam, and Swinkels, 2019 ).
To date, studying the performance of government bonds is challenging and has faced three main criticisms: 1) researchers focus on the US sample; 2) they start post-1980 ( a period characterized by declining yields) and they 3) use techniques more subject to p-hacking (i.e., predictive regressions).
The authors of this study try to eliminate the critiques of earlier studies by analyzing a deep sample of 70 years of international bond returns starting in 1950, a period characterized by two secular rate cycles. In addition, they use a testing framework that builds upon trading strategies, which allows the team to overcome estimation problems of the predictive regressions critiques (e.g. overlapping data, persistent regressors), and examine practical aspects relevant for practitioners like trading costs.
They also investigate whether it is possible to time international bond markets.
By looking at predictors like the 1) steepness of the yield curve (i.e. yield spread), 2) past bond returns (i.e. bond trend), 3) past equity returns, and 4) past commodity returns, as well as their combination to study joint forecasting power, the authors find:
Government bond returns display predictable dynamics. According to the authors, an interesting venue for future research is the development of asset pricing theories that account for these predictable dynamics. From a practitioner perspective, the timing of international bond market returns offers substantial and exploitable opportunities to investors. Active management of government bonds, if successful, can therefore add value by predicting the direction of yield changes.
We examine the predictability of government bond returns using a deep sample spanning 70 years of international data across the major bond markets. Using an economic, trading-based testing framework we find strong economic and statistical evidence of bond return predictability with a Sharpe ratio of 0.87 since 1950. This finding is robust over markets and time periods, including 30 years of out-of-sample data on international bond markets and a set of nine additional countries. Furthermore, the results are consistent over economic environments, including prolonged periods of rising or falling rates, and is exploitable after transaction costs. The predictability relates to predictability in inflation and economic growth. Overall, government bond premia display predictable dynamics and the timing of international bond market returns offers exploitable opportunities to investors.
Predicting Bond Returns? Focus on GDP Growth and Inflation Indicators was originally published at Alpha Architect. Please read the Alpha Architect disclosures at your convenience.