Yield Curve Factors, Term Structure Volatility, and Bond Risk Premia

We introduce a Nelson-Siegel type interest rate term structure model with the underlying yield factors following autoregressive processes revealing time-varying stochastic volatility. The factor volatilities capture risk inherent to the term structure and are associated with the time-varying uncertainty of the yield curves level, slope and curvature. Estimating the model based on U.S. government bond yields applying Markov chain Monte Carlo techniques we find that the yield factors and factor volatilities follow highly persistent processes. Using the extracted factorsto explain one-year-ahead bond excess returns we observe that the slope and curvature yield factors contain the same explanatory power as the return-forecasting factor recently proposed by Cochrane and Piazzesi (2005). Moreover, we identify slope and curvature risk as important additional determinants of future excess returns. Finally, we illustrate that the yield and volatility factors are closely connected to variables reflecting macroeconomic activity, inflation, monetary policyand employment growth. It is shown that the extracted yield curve components have long-term prediction power for macroeconomic fundamentals.