Essays on Bond Return Predictability and Liquidity Risk.

Summary If there is good information to forecast Treasury prices over time, how can this information be used to improve the investor's risk/reward and term structure modeling? This thesis aims to answer this question. The first chapter analyzes the predictive role of alternative measures of the liquidity premium of TIPS (Treasury Inflation-Protected Securities) over Treasury securities for excess government bond yields. The results show that the liquidity premium predicts positive (negative) excess returns for TIPS (nominal Treasury). I also find that the out-of-sample predictive power of liquidity for excess returns on nominal Treasuries appears to have been driven by the events of the recent financial crisis. On the other hand, I find empirically that there is also predictive power for out-of-sample excess TIPS yields during normal periods as well as bad periods.In the second chapter, I examine whether the TIPS liquidity premium can be considered as a so-called unspanned factor (i.e., whose value is not a linear combination of the yield curve) for predicting bond yields, but is not necessarily spanned by the U.S. yield curve. I consider an affine and Gaussian model of the term structure of zero-coupon U.S. Treasury bonds for all Treasuries and TIPS, with one unspanned factor: liquidity risk. In this model, the liquidity factor is constrained to affect only cross-sectional yields, but it does allow for the determination of bond risk premiums. Empirical evidence suggests that the liquidity factor does not affect the dynamics of bonds under risk-neutral probability, but does affect those dynamics under the historical measure. Therefore, the information contained in the yield curve proves insufficient to fully characterize the price change of curvature risk. In the third chapter, I estimate, by non-parametric methods, the optimal bond portfolio choice for a representative agent who acts in an optimal way with respect to his expected utility over the next period, from the liquidity signal observed ex ante. Considering the different measures of liquidity, I find that the liquidity differential between nominal bonds and TIPS appears to be a significant factor in the choice of the US government bond portfolio. Indeed, the conditional allocation to risky assets decreases as market liquidity conditions deteriorate, and the market liquidity effect decreases with the investment horizon. I also find that the predictability of bond returns translates into better allocation and performance both within and outside the sample.