The risk premium of each asset (the difference between the expected return arising from the asset and the risk-free interest rate in the economy) is determined by the correlation of the future receipts that the asset peaks with the market portfolio (stocks, real estate, etc.). , Is expected to have a negative risk premium (its price is higher.) The reason investors will be willing to pay a higher price at present is because the asset provides “insurance” to their holding portfolio.
Conversely, if the asset is expected to yield high receipts while their portfolio performance is high, investors will be willing to pay less at present, so the asset is likely to have a positive risk premium. Government bonds are no exception in this regard. The future prices of linked and unindexed government bonds are uncertain (they vary depending on the level of interest rates that will prevail in the economy in the future) and therefore investors will demand a risk premium for them.
The risk premium on holding an unlinked bond for a certain period of time is an amount of the risk premium required by investors for holding the bond linked to that period, in addition to another risk premium, called the “inflation risk premium”. The reason why investors demand additional compensation for the holding of an unlinked bond is that the payments that the unlinked bond pays are uncertain in real terms, since future inflation is unknown – unlike index-linked linked bond payments. As noted, this premium can be positive or negative, depending on its correlation with the market portfolio.
Daniel’s study examined the period from January 1985 to December 2019, and presents the results of the breakdown of the yield curve of government bonds in Israel, into two parts: the expected real interest rate and the risk premiums. This decomposition is based on an accepted model in the literature of the Affine Term Structure Models (ATSM) type. Figure 1 shows the breakdown of the monthly nominal yield to 10 years, from May 2001 (the date on which the Israeli government began issuing nominal long-term bonds) to December 2019. The figure shows that the 10-year yield has fallen sharply in recent years, reflecting declining interest rates In Israel and around the world.
In addition, it can be seen that the decrease in the nominal interest rate in Israel was not only due to expectations of a decrease in interest rates in the future, but also to a decrease in the real risk premium and the inflation risk premium. Both premiums have actually dropped from 2015 to negative levels. The negative premiums mean that investors are practically willing to pay to hold the nominal bonds because they provide hedging to the market portfolio.
Dissolution of the nominal return to 10 years
Source: Bank of Israel