Return Dynamics of Index-Linked Bond Portfolios

Abstract

Bond returns are known to exhibit mean reversion, autocorrelation, and other dynamic properties that differentiate them from stock returns. Index-linked bonds bring in further characteristics that complicate the task of modeling returns over time. Such models are essential, however, in strategic portfolio analysis and quantitative risk management. This article shows that the modeling of index-linked bond portfolios can be reduced to statistical modeling of the portfolio’s yield to maturity and the underlying index. For these quantities, many well-established models already exist. Using historical data from 12 different markets, the authors show that the two risk factors consistently explain more than 98% of monthly return variations over the past decade, including the recent financial crisis.

TOPICS: Portfolio construction, statistical methods, in markets