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How are long term capital market expectations set in the industry?

I'm looking to get some pointers about setting long term assumptions for fixed income asset classes like global high yield credit, or government bonds and how we could model or forecast the yield.

We could probably use term premia or add a liquidity premia to the current yield, then the question becomes one of estimating these premia...

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closed as unclear what you're asking by LocalVolatility, phdstudent, amdopt, Bob Jansen Mar 27 '18 at 10:49

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Broadly speaking, there are three approaches to setting long-term Capital Market Assumptions (CMA):

  • Building-block approach: This approach starts with the expected return for cash, then adds various relevant risk premia. In the context of fixed income assets, we'd be adding bond risk premium for risk-free government bonds, credit risk premium for credits, etc., as you've alluded to. (This is ridiculously popular, but I tend to dislike it. Cash return is impossible to forecast accurately because of uncertainties surrounding monetary policy cycles, and estimating ex-ante risk premium is no easy thing either.)
  • Empirical approach: This involves using time-series models to generate future expected return forecasts. Amongst these models, BVAR has been particularly popular in recent years. For fixed income securities, the econometric approach is quite useful for forecasting future default rates and simulating bond index durations.
  • Theoretical approach: Some practitioners use theoretical models to generate return assumptions. For example, to determine equity risk premium, using a multi-stage dividend discount model is the mainstream approach.

I won't go into the details of these methods because there are excellent whitepapers written by smarter people. Some of my favorites include:

I'll also comment that for generating long-term CMAs, simpler methods are usually very successful; this is particularly true for fixed income assets. For example, the chart below shows 10-year bond yield versus next 10-year realized return of continuously rolling on-the-run 10-year Treasuries. You can marginally improve upon this result (e.g., by including an expected rolldown return), but I wonder whether it's worth the effort.

enter image description here

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  • $\begingroup$ Thanks Helin! Extremely helpful. Looking at the article from Research Affiliate, it seems that the main contributor for fixed income returns is the current yield. I wonder how much effort it will take to compute the other return components like rolldown return, valuation change, etc. which would require estimating a forecast yield curve over the next 10/20 years. And on your very last point about a more simplistic approach, is it to use Treasury futures as a point estimate of the 10Y yield? $\endgroup$ – hauterob Apr 2 '18 at 5:40

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