Common Factors in International Bond Returns

Abstract

In this paper we estimate and interpret the factors that jointly determine bond returns of different maturities in the US, Germany and Japan. We analyze both currency-hedged as well as unhedged bond returns. For currency-hedged bond returns, we find that five factors explain 96.5% of the variation of bond returns. These factors can be associated with changes in the level and steepness of the term structures in (some of) these countries. In particular, it turns out that changes in the level of the term structures are correlated across countries, while changes in the steepness of the term structures are country-specific. We find similar results for bond returns that are not hedged for currency risk. We show how the model can be used to calculate duration-type risk measures and Value at Risks for international bond portfolios, and compare the results with simpler models. Finally, we demonstrate how cross-currency interest rate derivatives can be priced with the model.

JEL Classification: E43, F21, G12, G15