A model for bond risk premia and the macroeconomy

July 15, 2023

An empirical analysis of the U.S. bond market since the 1960s emphasizes occasional abrupt regime changes, as defined by yield levels, curve slopes, and related volatility metrics. An arbitrage-free bond pricing model illustrates that bond risk premia can be decomposed into two types. One is related to continuous risk factors, traditionally summarized as the level, slope, and curvature of the yield term structure. The other type is related to regime-switching risk. Accounting for regime shift risk adds significant explanatory power to the model. Moreover, risk premia associated with regime shifts are related to the macroeconomic environment, particularly inflation and economic activity. The market price of regime shifts is strongly pro-cyclical and largely explained by these economic indicators. Investors apply a higher regime-related discount to bond values when the economy is booming.

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How to estimate credit spread curves

February 19, 2022

Credit spread curves are essential for analyzing lower-grade bond markets and for the construction of trading strategies that are based on carry and relative value. However, simple spread proxies can be misleading because they assume that default may occur more than once in the given time interval and that losses are in proportion to market value just before default, rather than par value. A more accurate method is to estimate the present value of survival-contingent payments – coupons and principals – as the product of a risk-free discount factor and survival probability. To this, one must add a discounted expected recovery of the par value in case of default. This model allows parametrically defining a grid of curves that depends on rating and maturity. The estimated ‘fair’ spread for a particular rating and tenor would be a sort of weighted average of bonds of nearby rating and tenor.

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The duration extraction effect

April 13, 2019

Under non-conventional monetary policy central banks influence financial markets through the “portfolio rebalancing channel”. The purchase of assets changes the structure of prices. A particularly powerful portfolio rebalancing effect arises from duration extraction, i.e. the combined size expansion and duration extension of the assets that have been absorbed onto the central bank’s balance sheet. Duration extraction has a significant and persistent impact on the yield curve and the exchange rate. Importantly, the effect arises from hints or announcements of new parameters for the future stock of assets. Given the large size of central bank balance sheets, this explains why changes in expected asset purchases, re-investments or redemption plans have a profound impact on financial markets.

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Seasonal effects in commodity futures curves

July 7, 2018

Seasonal fluctuations are evident for many commodity prices. However, their exact size can be quite uncertain. Hence, seasons affect commodity futures curves in two ways. First, they bias the expected futures price of a specific expiry month relative that of other months. Second, their uncertainty is an independent source of risk that affects the overall risk premia priced into the curve. Integrating seasonal factor uncertainty into an affine (linear) term structure model of commodity futures allows more realistic and granular estimates of various risk premia or ‘cost-of-carry factors’. This can serve as basis for investors to decide whether to receive or pay the risk premia implied in the future curve.

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Term premia and macro factors

June 30, 2018

The fixed income term premium is the difference between the yield of a longer-maturity bond and the average expected risk-free short-term rate for that maturity. Abstractly, it is a price for commitment. The term premium is not directly observable but needs to be estimated based on the assumptions of a term structure model that separates expected short-term rates and risk premia. Model assumptions become a lot more realistic if one includes macroeconomic variables. In particular, long-term inflation expectations plausibly shape the long-term trend in yield levels. Also cyclical fluctuations in inflation and unemployment explain slope and curvature to some extent. A recent IMF paper proposes a methodology for integrating macroeconomic variables in a conventional affine term structure model.

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Using yield curve information for FX trading

May 12, 2018

FX carry trading strategies only use short-term interest rates (and forward basis) as signal. Yet both theoretical and empirical research suggests that the whole relative yield curve contains important information on monetary policy and risk premia. In particular, the curvature of a yield curve indicates – to some extent – the speed of adjustment of the short rate towards a longer-term yield. Since relative curvature between two countries is therefore a measure of the relative trajectory of monetary policy it is a valid directional signal for FX trading. Indeed, recent empirical research suggests that this signal is statistically significant. A curvature-based trading rule produces higher Sharpe ratios and less negative skewness than conventional FX carry strategies.

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Fixed income carry as trading signal

April 28, 2018

Empirical evidence for 27 markets suggests that carry on interest rate swaps has been positively correlated with subsequent returns for the past two decades. Indeed, a naïve strategy following carry as signal has produced respectable risk-adjusted returns. However, this positive past performance masks the fundamental flaw of the carry signal: it disregards the expected future drift in interest rates and favours receiver position in markets with very low real rates. In the 2000s and 2010s this oversight mattered little because inflation and yields drifted broadly lower. If the inflation cycle turns or just stabilizes, however, short-term rates normalization should become very consequential. Indeed, enhancing the IRS carry signal by a plausible medium term drift in short rates has already in the past produced more stable returns and more convincing actual “alpha”.

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Cross-asset carry: an introduction

July 15, 2017

Carry can be defined as return for unchanged market prices and is easy to calculate in real time across assets. Carry strategies often reap risk premia and implicit subsidies. Historically, they have produced positive returns in FX, commodities, bonds and equity. Carry strategies can also be combined across asset classes to render diversification benefits. Historically, since 1990, the performance of such diversified carry portfolios has been strong, with Sharpe ratios close to 1, limited correlation to benchmark indices and less of a downside skew that FX carry trades.

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Understanding negative inflation risk premia

May 13, 2017

Inflation risk premia in the U.S. and the euro area have disappeared or even turned negative since the great financial crisis, according to various studies. There is also evidence that this is not because inflation uncertainty has declined but because the balance of risk has shifted from high inflation problems to deflationary recessions. Put simply, markets pay a premium for bonds and interest rate swap receivers as hedge against deflation risk rather than demanding a discount for exposure to high inflation risk. This can hold for as long as the expected correlation between economic-financial performance and inflation remains broadly positive.

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Inflation: risk without premium

December 31, 2016

Historically, securities that lose value as inflation increases have paid a sizable risk premium. However, there is evidence that inflation risk premia have vanished or become negative in recent years. Macroeconomic theory suggests that this is related to monetary policy constraints at the zero lower bound: demand shocks are harder to contain and cause positive correlation between inflation and growth. Assets whose returns go down with higher inflation become valuable proxy-hedges. As a consequence, inflation breakevens underestimate inflation. Bond yields would rise disproportionately once policy rates move away from the zero lower bound.

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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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