Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Interpreting carry or non-zero yield spreads

• Non-zero yield spreads can reflect the market’s expectations about future rate changes or growth, or they can reflect higher yielding assets’ prospective return advantage. In all asset markets we can identify interpretations analogous to these two. The two alternative interpretations can be called risk-neutral hypotheses and risk premium hypotheses.

• The uncovered interest parity hypothesis for currencies, the pure expectations hypothesis for interest rates, and analogous risk-neutral investor hypotheses for other asset classes presume that all assets have the same expected returns as the riskless asset. For consistency, market expectations must then imply price movements that cause capital losses just sufficient to offset any initial yield advantage.

• Risk premium hypotheses make the polar opposite claim: yield spreads only reveal required return differentials and reveal nothing about market expectations on future rates.

• Empirical “horse races” show that yield spreads have been better predictors of future returns than of “offsetting” market rate or growth changes. Over long histories, yield-seeking (positive-carry) strategies have been profitable in all asset classes studied. Such evidence contradicts risk-neutral hypotheses and supports risk premium hypotheses. (Even if carry losses are rare, their size and timing can justify large risk premia.)

• However, empirical evidence does not speak to the rationality of high prospective ...