Academic journal article Financial Services Review

Term Spreads and Predictions of Bond and Stock Excess Returns

Academic journal article Financial Services Review

Term Spreads and Predictions of Bond and Stock Excess Returns

Article excerpt

Several studies conclude that a long-shor term spread, in conjunction with one or more other variables, jointly predict returns on long-term corporate bonds and stocks. We extend these studies by examining the predictive content of intermediate-short term spreads, and by examining regressions of excess returns on l.5-year to 20-year Treasury bonds. We show that the bond market prices an intermediate-short term spread, and not a long-short spread. We believe individuals should vary their debt-equity mix with the level of a default risk premium or the stock market's dividend yield, and vary their debt porfolios' maturity with an intermediate-short term spread.

Several studies conclude that a term spread, in conjunction with one or more other variables, jointly predict returns on long-term corporate bonds and stocks. Fama (1976), Startz (1982), Shiller, Campbell, and Schoenholtz (1983), Fama (1984), Fama and French (1989), and Fraser (1995) conclude bond returns vary with a term spread. Campbell (1987), Fama and French (1989), Fama (1990a), Schwert (1990), Chen (1991), and Fraser (1995) conclude stock returns vary with a term spread. Related results are presented by Keim and Stambaugh (1986), Fama (1986), Fama and Bliss (1987), Stambaugh (1988), Hardouvelis (1994), Elton, Gruber, and Mei (1996), and Jensen, Mercer, and Johnson (1996).

Most of these studies use a long-short term spread-the spread between a long-term yield and a short-term yield-to predict returns on long-term securities. There is also a widely stated but unproven explanation about why the term spread predicts returns. "[T]he spread tracks a term or maturity risk premium in expected returns that is similar for all long-term assets. A reasonable and old hypothesis is that the premium compensates for exposure to discount-rate shocks that affect all long-term securities (stocks and bonds) in roughly the same way" (Fama & French, 1989, p. 24). In short, the term spread tracks embedded term risk premiums, which are investors' rewards to bearing interest rate or duration risk.

We have two concerns with this literature, which provide the motivation for this paper. First, since regressions have been tested on returns on long-term assets but not returns on shorter-term bonds, no one has adequately tested the suspicion that the term spread tracks the rewards to bearing duration risk. To verify this hypothesis, one must show that the impact of the term spread varies across bond maturities. To be specific, in regressions of bond returns on forecasting variables, the slopes for the term spread should be approximately linearly related to bonds' durations.

Second and more important, we suspected that an intermediate-short spread would do a better job than a long-short spread at (1) tracking embedded term premiums and, therefore, (2) predicting bond and stock returns. A long-short term spread can be separated into a long-intermediate and an intermediate-short spread. Some prior studies support the preferred-habitat theory (e.g., Domian, Maness, & Reichenstein, 1998; McCallum, 1975, McCulloch, 1975). This theory recognizes that some investors prefer and strongly influence the short end of the bond market, while others prefer and influence the long end. It follows that an intermediate-short spread could closely track a term risk premium, while a long-intermediate spread may not.

For many investors, a bond's duration is a good measure of its risk. These investors dominate the short end of the yield curve--that is, they are the marginal price setters. So, term premiums should rise with maturity in the short end of the yield curve, and an intermediate-short term spread should proxy for the reward to bearing duration risk. In contrast, life insurance companies and defined-benefit pension plans dominate the long end of the yield curve. They do not view long-term bonds as riskier than intermediate-term bonds. In fact, they often prefer long duration bonds because they better match the durations of their liabilities. …

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