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Yields and Their Components

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1. Introduction

In this note I discuss the components of Treasury yields, most notably — the "bond risk premium" (BRP). The purpose for this is to better understand the reasons for movements in yields, since, as we will see later, different components of yields are affected by different drivers. Understanding the drivers of the yield components can then help facilitate more appropriate positioning of one's fixed income portfolio. In addition, being able to decompose the yield into pieces can be helpful in forecasting the bond's future return. Lastly, we also offer some predictions of the future path of long-term Treasury yields.

2. Components of the Yield

2.1. Definitions. The yield of Treasury bonds can be decomposed into the following two components: expected average nominal short-term yield and bond risk premium (BRP). The first component is the market's best forecast of short-term yields over the lifetime of the bond, while the second component (BRP) is the additional compensation required by market participants for the possibility that the realized short-term yields over the lifetime of the bond might be different from the expected short-term yields at the time of the purchase of the bond. The larger the potential for the future realized yields and the expected short-term yields being different as well as the more fearful (i.e., more risk-averse) the investors feel, the larger the BRP. Thus, if the future short-term rates over the lifetime of the bond were fixed at the time of the purchase of the bond, BRP would be equal to zero. For this reason, the expected average nominal short-term yield component is sometimes referred to as the "risk- neutral yield" (see, for example, Bernanke 2015b) — the yield on a long-term Treasury bond that would be required by risk-neutral investors. The expected average nominal short-term yield component can be further broken down into expected average real short-term yield and the expected inflation over the lifetime of the bond.

 

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