Quantitative Research

Yields and Their Components

Download the full PDF

 

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.

 

Download the full PDF

The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.

Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.

Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio.

An investment cannot be made directly into an index.

Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

FOR INVESTMENT PROFESSIONAL USE ONLY.