Consumption risk and the cross-section of government bond returns

In this paper we provide a consumption-based explanation of risk in nominal US Treasury bond portfolios. We use a consumption-CAPM with Epstein-Zin-Weil recursive preferences. Our model introduces two sources of risk: uncertainty about current consumption (reflected in contemporane- ous consumption growth) and uncertainty about prospects of consumption in a long run (reflected in innovations to expectations about future onsumption growth). We use a novel approach to estimate pricing factors in our model: we employ a factor-augmented VAR model with common factors, extracted from a large panel of macroeconomic and financial data, as state variables. We find that the important source of risk in US bonds is related to uncertainty in prospects in future consumption and it induces a positive and signficant risk premium. We find as well that covariance risk related to innovations in expectations about future consumption growth is greater for long term bond portfolios than for short term bond portfolios, which is consistent with a duration measure of risk and justifies why long term bonds require greater premium than short term bonds. Our model explains well the cross-sectional variation in average excess returns of bonds with different maturities over the period 1975-2011 and compares favorably with competing models.