Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds

by John Y. Campbell, Adi Sunderam & Luis M. Viceira

Overview — Are nominal government bonds risky investments that investors must be rewarded to hold? Or are they safe investments, whose price movements are either inconsequential or even beneficial to investors as hedges against other risks? U.S. Treasury bonds have performed well as hedges during the financial crisis of 2008, but the opposite was true in the late 1970's and early 1980's. John Y. Campbell, a Visiting Scholar at HBS, Harvard Ph.D. candidate Adi Sunderam, and HBS professor Luis M. Viceira explore such changes over time in the risks of nominal government bonds. Key concepts include:

  • A changing covariance between nominal and real variables is of central importance in understanding the term structure of nominal interest rates.
  • Analyses of asset allocation traditionally assume that broad asset classes have a stable structure of risk over time; these new results, however, suggest that in the case of nominal bonds, at least, this assumption is seriously misleading.

Author Abstract

The covariance between US Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953 - 2005, it was particularly high in the early 1980's and negative in the early 2000's. This paper specifies and estimates a model in which the nominal term structure of interest rates is driven by five state variables: the real interest rate, risk aversion, temporary and permanent components of expected inflation, and the covariance between nominal variables and the real economy. The last of these state variables enables the model to fit the changing covariance of bond and stock returns. Log nominal bond yields and term premia are quadratic in these state variables, with term premia determined mainly by the product of risk aversion and the nominal-real covariance. The concavity of the yield curve-the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields-is a good proxy for the level of term premia. The nominal-real covariance has declined since the early 1980's, driving down term premia.

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