Defining and Exploiting Value in US Treasury Bonds

Abstract

In this article, we propose a definition of value in Treasury bonds that, we believe, is more satisfactory than definitions found in the recent literature, and that allows for statistically significant and economically relevant predictions of cross-sectional excess returns. Our value pricing factor exploits the differences between the market and the theoretical values of Treasury bonds, where the theoretical value is assessed using an economically-justifiable Gaussian dynamic term structure model. We show that the profitability of the strategy we build using our value signal is statistically and economically significant and is closely linked to the Treasury market volatility. We provide an explanation for this strong link using arguments similar to what can be found in the recent literature on liquidity in Treasuries; and we show that our value signal is not subsumed by the best-known return-predicting factors. With an eye to practical applications, we also present a long-only version of our strategy.

TOPICS: Analysis of individual factors/risk premia, factor-based models, style investing