Understanding Bond Risk Premia

We decompose yields into long-horizon expected inflation and maturity-related cycles to study the predictability of bond excess returns. Cycles capture the risk premium and the business cycle variation of short rate expectations. From cycles, we construct a forecasting factor that explains up to above 50% (30%) of in-sample (out-of-sample) variation of annual bond returns. The factor varies at a frequency higher than the business cycle, and predicts real activity at long horizons. It also aggregates information from different macro-finance predictors of bond returns. Our decomposition reveals why bond returns are predictable by a linear combination of forward rates or the term spread.