This paper provides an empirical description of the behaviour of excess returns on UK government discount bonds in
terms of risk factors such as the forward premium, the slope of the term structure, dividend yields and excess stock
returns. We identify the existence of a time-varying term structure of expected excess returns. Further, the dynamics
of the expected returns are characterised by regime-switching behaviour where the transition from one regime to the
other is controlled by the slope of the term structure of interest rates. The first regime, which is characterised by flat
or downward sloping term structures, occurs during periods of economic recession. The second regime, which is
characterised by upward sloping term structures, occurs during periods of economic expansion. The main risk factors
explaining expected returns are the slope of the term structure in the recessionary regime and the excess stock returns
in the expansionary regime
