AN ASSESSMENT OF THE RELATIVE IMPORTANCE OF REAL INTEREST-RATES, INFLATION, AND TERM PREMIUMS IN DETERMINING THE PRICES OF REAL AND NOMINALUK BONDS

We use a vector autoregression (VAR) to decompose unanticipated bond r eturns into news about fundamentals (expected real interest and inflat ion rates) and expected risk premiums. This decomposition is applied t o U.K. short- and long-maturity nominal bonds, and to U.K. index-linke d bonds. We also examine the sources of relative conventional and real bond returns. The results suggest that for both bond types, real-rate news plays an insignificant role, and that even for ''real'' bonds in flation news is important. Both bonds are strongly influenced by news about future risk premiums, but these appear to reflect a common facto r that has little influence on their relative returns. News about infl ation dominates unanticipated relative returns, which appear to provid e a reliable source of information about inflation expectations.