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Our tests indicate that expected excess returns (returns net of the one-month Treasury bill rate) on corporate bonds and stocks move together. Dividend yields, commonly used to forecast stock returns, also forecast bond returns. Predictable variation in stock returns is, in turn, tracked by variables commonly used to measure default and term (or maturity) premiums in bond returns. The default-premium variable (the default spread) is the difference between the yield on a market portfolio of corporate bonds and the yield on Aaa bonds. The term- or maturity-premium variable (the term spread) is the difference between the Aaa yield and the one-month bill rate.
The dividend yield and the default spread capture similar variation in expected bond and stock returns. The major movements in these variables, and in the expected return components they track, seem to be related to long-term business episodes that span several measured business cycles. The dividend yield and the default spread forecast high returns when business conditions are persistently weak and low returns when conditions are strong.
The term spread is more closely related to the shorter-term business cycles identified by the National Bureau of Economic Research (NBER). In particular, the term spread -and the component of expected returns it tracks -are low around measured business-cycle peaks and high near troughs.
There are clear patterns across assets in the slopes from regressions of returns on the forecasting variables. The slopes for the term spread are positive and similar in magnitude for all the stock portfolios and (long-term) bond portfolios we examine. This suggests that the spread tracks a term or maturity premium in expected returns that is similar for all long-term assets. A reasonable and old hypothesis is that the premium compensates for exposure to discount-rate shocks that affect all long-term securities (stocks and bonds) in roughly the same way.
In contrast to the slopes for the term spread, the slopes for the default spread and the dividend yield increase from high-grade to low-grade bonds and from bonds to stocks. This pattern corresponds to intuition about the business risks of the assets. that is, the sensitivity of their returns to unexpected changes in business conditions. The slopes suggest that the default spread and the dividend yield track components of expected returns that vary with the level or price of some business-conditions risk.
Does the expected-return variation we document reflect rational pricing in an efficient market? On the plus side, it is comforting that three forecasting variables. all related to business conditions. track common variation in the expected returns on bonds and stocks. It is appealing that the term spread, known to track a maturity premium in bond returns, identifies a similar premium in stock returns. It is also appealing that a measure of business conditions like the default spread captures expected-return variation that increases from high-grade bonds to stocks in a way that corresponds to intuition about the business-conditions risks of assets. Finally, it is comforting that variation in the dividend yield, which might otherwise be interpreted as the result of ‘bubbles’ in stock prices, forecasts bond returns as well as stock returns, and captures much the same variation in expected bond and stock returns as the default spread.
What one takes as comforting evidence for market rationality is, however, somewhat a matter of predilection. As always, the ultimate judgment must be left to the reader.