Working Paper | HBS Working Paper Series | 2013

Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds

by John Y. Campbell, Adi Sunderam and Luis M. Viceira


The covariance between U.S. Treasury bond returns and stock returns has moved considerably over time. While it was slightly positive on average in the period 1953–2009, it was unusually high in the early 1980s and negative in the 2000s, particularly in the downturns of 2000–2002 and 2007–2009. This paper specifies and estimates a model in which the nominal term structure of interest rates is driven by four state variables: the real interest rate, temporary and permanent components of expected inflation, the "nominal-real covariance" of inflation, and the real interest rate with the real economy. The last of these state variables enables the model to fit the changing covariance of bond and stock returns. Log bond yields and term premia are quadratic in these state variables, with term premia determined by the nominal-real covariance. The concavity of the yield curve―the level of intermediate-term bond yields, relative to the average of short- and long-term bond yields―is a good proxy for the level of term premia. The nominal-real covariance has declined since the early 1980s, driving down term premia.

Keywords: Inflation and Deflation; Bonds; Interest Rates; Investment Return; Risk Management; United States;


Campbell, John Y., Adi Sunderam, and Luis M. Viceira. "Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds." Harvard Business School Working Paper, No. 09-088, January 2009. (Revised January 2013.)