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Berndsen, Jan
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Danmarks Nationalbank Working Papers 10
Many financial institutions voluntarily undertake additional interest rate exposure, due to their shortterm funding and the placements of their assets in longer term bonds. Based on realised total bond returns of the major bond markets this paper assesses whether a fixed-income investor is actually rewarded by taking this additional interest rate risk. Unfortunately, the question raised in the title of this article can not clearly be answered. The outcome of the empirical analysis has shown that returns, return volatilities and their correlations are time-varying. However, some investment policy implications and conclusions can be stated, but caution is warranted when interpreting the empirical findings. When various bullet-portfolio strategies are observed a concave (excess) risk/return trade-off pattern can be found. This implies that the efficiency of duration extension is limited. The major government bond and US agency markets do reward interest rate risk, but (excess) returns do not increase linearly with return volatility. Generally, the reward for taking additional interest rate risk is the highest at the front end of the curve, and diminishes as the slope of the excess returns curve flattens from the one-to-threeyear part of the curve. In other words, if a fixed-income investor wanted to obtain higher excess returns by taking more interest rate risk during this long sample period, he should have invested (more) in bonds up to a maturity of approximately two years. Interestingly, the observed excess risk/return trade-off is unstable over time. Different risk/reward patterns that hold across periods are found, and seem to be dependent on macro-economic business cycles. In a bearish interest rate climate, taking additional interest rate risk is not rewarded at all. In these circumstances, a fixed-income investor has a strong incentive to lower the long-run benchmark duration. In addition, it should be noticed that long-duration bonds may be good investments for investors with longduration liabilities. Finally, based on historical interdependencies a fixed-income investor can improve the risk/return characteristics of a bullet treasury bond portfolio with a given interest rate exposure, by allocating the interest rate exposure across maturities and/or international government bond markets. The inclusion of US agency bonds in a US treasury portfolio also improved the risk/return characteristics of the overall portfolio, but to a much lesser extent.
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Working Paper

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