Shrinking the Term Structure

Abstract

We develop a conditional factor model for the term structure of Treasury bonds, which unifies non parametric curve estimation with cross-sectional asset pricing. Our factors are investable portfolios and estimated with cross-sectional ridge regressions. They correspond to the optimal non parametric basis functions that span the discount curve and are based on economic first principles. Cash flows are covariances, which fully explain the factor exposure of coupon bonds. Empirically, we show that four factors explain the discount bond excess return curve and term structure premium, which depends on the market complexity measured by the time-varying importance of higher order factors. The fourth term structure factor capturing complex shapes of the term structure premium is a hedge for bad economic times and pays off during recessions.

Keywords: Term structure of interest rates, bond returns, factor space, U.S. Treasury securities, non-parametric method, principal components, machine learning in finance, reproducing kernel Hilbert space

JEL Classification: C14, C38, C55, G12