Bond Risk Premia and Discount Rate Variation in Brazil

Long-duration public bonds denominated in local currency have been traded with liquidity in Brazil since the late 2000s. I use the twelve years or so of now available data to study bond risk premia. As previously documented for the US, a single tent-shaped combination of forward rates predicts bonds’ excess returns. R2 surpasses 0.40. The same return-forecasting factor also predicts equity stock excess returns (R2 ≈ 0.18), and returns on the Real-Dollar carry trade (R2 ≈ 0.28), even after controlling for domestic interest, dividend-yield and US risk premium variation. The return factor is slightly correlated with the MSCI index and domestic interest, but disconnected from other macroeconomic and international variables. I input it along with term structure principal components on a exponential-affine model, and characterize model dynamics with a simple pair of co-movements involving the return factor and the level principal component, a variable I show to be highly correlated with domestic inflation and US bond risk premia, and whose shocks affect marginal utility in the model specification with the best fit