Why Government Bond Returns Depend on Yield Changes as Well as Yield

Summary

The document explains why a government bond’s yield to maturity is not, by itself, a forecast of its realized return over a future holding period. Under a no-default assumption, coupon payments can be forecast relatively directly, but the bond’s price at the end of the period depends on how yields change. Initial yield can still offer predictive information, yet it does not capture the full return.

It points to research on forecasting bond returns, including studies that examine term spreads, real yields, valuation measures, and momentum. The cited research reports statistically significant predictability in bond returns, including across international markets. These findings motivate using explanatory variables alongside starting yields. The document does not give a specific forecasting model, estimates, or implementation details, and it cautions implicitly that future yield changes are difficult to predict. Its discussion concerns expected returns over a chosen horizon, which can differ substantially from the yield quoted at purchase.

Key ideas

• A government bond’s yield to maturity does not determine its realized return over a future holding period.
• Coupon payments are comparatively straightforward to forecast under a no-default assumption.
• Changes in bond prices, driven by realized yield changes, can dominate holding-period returns.
• Initial yields provide some predictive information but are not a complete return forecast.
• Research identifies term spreads, real yields, valuation measures, and momentum as possible predictors.

Tags

# Bond Annual Expected Return


# Bond Annual Expected Return












I am working on finding the expected return of bonds. To find the expected return for corporate bonds I have been using a transition matrix showing the probability for it to default and a recovery rates. But, currently I am stuck on finding how to find the expected annual return of government bonds. Would it just me the YTM? Can anyone help? Thanks

## Answer by Sharad (score 1)

https://quant.stackexchange.com/a/75186

Forecasting expected returns on sovereign bonds over a time period is equivalent to forecasting expected coupon payments (straightforward under a no-default assumption) and forecasting expected price changes (very challenging). So, while the initial yield does offer some predictive value, the total return over a time period will be driven by realized yield changes.

A significant amount of research has gone into finding the best set of variables for predicting US bond returns. "Forecasting U.S. Bond Returns" by Antti Ilmanen (Journal of Fixed Income, 1997) offers an accessible introduction to this topic along with a set of variables (Term Spread, Real Yield, Inverse Wealth, Momentum) that show some predictive ability. A more recent study, "Predicting Bond Returns: 70 Years of International Evidence" by Baltussen et al (Financial Analysts Journal, 2021), revisits this study and others using a more comprehensive set of data and finds statistically significant bond return predictability. These two papers should give you an excellent entry point into this area.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.