Historical Treasury Term Premia: Huge!
This post is an illustration of the concepts discussed inwards my primer on the term premium. Although nosotros practice non actually know what the term premium is at whatever detail time, historical excess returns over a long catamenia of fourth dimension should average out nigh the average term premium. However, those excess returns convey been implausibly high. Why this matters: if nosotros practice non know what the term premium is, nosotros cannot know what the Treasury bond plication is pricing for the Fed outlook.
In the nautical chart below, I demo the demeanour of the realised (historical) excess returns for the 5-year Treasury.
To explicate the chart, inwards the transcend panel nosotros run across the 5-year Treasury yield versus the 5-year average of the effective Fed Funds charge per unit of measurement for the next v years. Since FRED does non notwithstanding convey a fourth dimension car option, the information for the average ends inwards 2008 (i.e., v years ago).
In the bottom panel, the “Realised Excess Return” is the 5-year bond yield minus the average fed funds charge per unit of measurement depicted above. This is a fairly skillful approximation of the excess supply of a buy-and-hold seat inwards a 5-year bond entered into a detail appointment versus a cash investment.
For example, inwards Oct 2008 (the terminate indicate of my sample), the 5-year yield was 2.73%, piece the realised average effective fed funds charge per unit of measurement since too therefore was 0.16%, generating an excess supply of 2.57%.
The tabular array below shows the average realised excess returns for diverse periods, for the 2-, 5-, too 10-year points on the Treasury Curve. (Charts for the 2-year too 10-year are at the bottom of this post.)
Maturity | Start Date of Data | Mean Excess Return | ||
Entire Dataset | Since 1980-01-01 | Since 1990-01-01 | ||
2-year | 1976 | 0.51% | 0.80% | 0.81% |
5-year | 1962 | 0.77% | 1.95% | 1.74% |
10-year | 1962 | 1.01% | 3.02% | 2.56% |
The sense for the 5-year maturity is specially interesting. The negative premia pre-1980 could live explained past times the diverse regulations that led to “financial repression”: yields held below what marketplace seat forces would suggest. Once the deregulation of involvement rates was completed, the premium has non been significantly been negative. Although the disinflation post-1980 was a surprise, the disinflation was largely finished past times 1990. The marketplace seat did non select grip of on to this, too the 5-year yield was on average 1.74% inwards a higher house the realised fed funds charge per unit of measurement since 1990. In my opinion, the historical premium appears outsized for the total of cost peril associated amongst a 5-year bond; for instance it is virtually double 5-year investment degree spreads correct directly (using the CDX index). Such a persistent immature lady past times the marketplace seat is difficult to explicate if it is inwards fact efficient.
This makes it difficult to calibrate a model for calculating the “true” expected path of involvement rates afterwards adjusting for a term premium. If nosotros blindly applied the post-1990 premium to the electrical flow curve, the implied expected average fed funds charge per unit of measurement over the side past times side v years is unopen to -0.25%. This does non appear real plausible.
This also messes upward whatever models for the fair value of bond yields which are based on historical data. In the post-1990s sample, the whole bond plication exhibited a real large term premium (or else marketplace seat forecasts were consistently terrible). Therefore yous terminate upward basing your model target upon a too-high yield. I believe that this was a mutual analysis fault made for the past times xxx years, which explains the persistence of the bull marketplace seat (whereas excess returns should theoretically live a random walk).
In an upcoming post, I volition plow to model-based approaches to calculating the term premium – affine plication models.
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