Economics - reading 11

On page 223, they talk about the ability to hedge recession risk and how its one of the drivers of term premiums.

They say a low term premium warranted if aggregate demand drives inflation and growth. The nominal bonds tend to be negatively correlated with growth in these cases.

What this have to do with ability to hedge recession risk? Maybe tired but don’t see connection.

I have the same question. Does Anyone have solution?

A nominal bond means the bonds pays fixed coupons, regardless of the state of economy.

A negative correlation between nominal bond return and economic growth would imply that:

  • when economy is growing , inflation rate and growth will be higher --> higher YTM --> lower bond price --> lower bond return.

  • when economy is in a recession , inflation rate and growth will be lower --> lower YTM --> higher bond price --> higher bond return.

So in a way, when economy is in a recession, investors benefit from being invested in bonds (especially high quality ones) due to the fixed coupons (i.e. certainty) that they receive from it, which is better relative to other investments like equity.

Since the bond hedges against recession risk (benefit), therefore investors will not require a higher risk premium from bonds.

If you compare to equities, which are typically positively correlated to economic growth; if the economy runs into a recession, equities will perform badly as well --> equities are a bad hedge against recession (no benefit). Therefore to make up for this, investors will need a higher risk premium to invest into equities (compared to bonds).