Bond Risk Premiums at the Zero Lower Bound

Abstract

This paper documents a signi…cantly stronger relationship between the slope of the yield curve and future excess bond returns on Treasuries from 2008-2015 than before 2008. This new predictability result is not matched by the standard shadow rate model with Gaussian factor dynamics, but extending the model with regime-switching in the (physical) dynamics of the factors at the lower bound resolves this shortcoming. The model is also consistent with the downwards trend in surveys on short rate expectations at long horizons, but requires a break in the level of its factors to closely …t the low level of these surveys since 2015.

Are Shadow Rate Models of the Treasury Yield Curve Structurally Stable?

“…n for the post-ELB sample taking lower values than those for the pre-ELB sample. The Campbell-Shiller beta for larger n's (such as n = 120 months) taking a more negative value in the post-ELB period than in the pre-ELB period is reminiscent of Andreasen et al (2019), who obtain similar results with actual yields 40 Somewhat not surprisingly, with limited amount of post-ELB period data, the standard errors for that period are fairly large. While these results therefore might not constitute a sufficient body of evidence by themselves, they are suggestive of a change in the pricing of interest rate risk, and further add to the finding in the previous section (Section 6.2) that the parameters that describe the market price of risk (Λ † parameters) have changed meaningfully between the two periods.…”

“…The Federal Open Market Committee (FOMC) specified a target range for the federal funds rate of 0 to 0.25 percent. Our sample ends before the most recent ELB episode in response to the COVID-19 outbreak.2 See, for example,Reifschneider and Williams (2000),Eggertsson and Woodford (2003),Nakata and Tanaka (2016), andJohannsen and Mertens (2016).3 In concurrent independent work,Andreasen, Jørgensen, and Meldrum (2019) document patterns in bond excess return regression that are suggestive of structural instability of shadow rate models, and propose a regime-switching shadow rate model.4 In Section 2, we provide a more detailed discussion referencing several macro models incorporating an ELB.…”