Defining and Exploiting Value in US Treasury Bonds Riccardo Rebonato, Jean-Michel Maeso, Lionel Martellini EDHEC Risk Institute, EDHEC Business School * May 28, 2019 Abstract In this paper we propose a definition of value in Treasury bonds that, we believe, is more satisfactory than definitions found in the re- cent literature, and that allows 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 sig- nal 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 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. 1 Introduction and Motivation Value has been recognized as one of the most important factors for equities at least since the pioneering work by Fama and McBeth (1973). In equities, the ratio of book to market value has traditionally been used as a proxy for the value factor. Natural as this choice is for this asset class, it is difficult to translate the concept of value to the fixed-income domain, and, for this reason, Fama and French (1993) have argued that value does not apply to fixed-income instruments in general, and to Treasury bonds in particular 1 . This seems to be at odds with recent literature, which claims to have found value (and momentum) ‘everywhere’. For instance Assness, Moskowitz and Pedersen (2013) have defined value for bonds as the (negative of the) 5-year bond returns * This research has benefited from the support of Amundi in the context of the “ETF and Passive Investment Strategies” Research Chair. 1 “... explanatory variables like size and book-to-market equity have no obvious meaning for government and corporate bonds. . . ” – Fama and French, 1993 1