Reduced form models of bond portfolios

TL;DR

This paper develops simplified return models for various bond portfolios using minimal risk factors, effectively capturing return variations and aiding risk management and portfolio construction.

Contribution

It introduces parsimonious models with one or two risk factors that explain most return variations in different bond portfolios, with interpretable risk factors.

Findings

Models explain most return variations in bond portfolios.

Few risk factors suffice for accurate modeling.

Models are suitable for risk management and portfolio design.

Abstract

We derive simple return models for several classes of bond portfolios. With only one or two risk factors our models are able to explain most of the return variations in portfolios of fixed rate government bonds, inflation linked government bonds and investment grade corporate bonds. The underlying risk factors have natural interpretations which make the models well suited for risk management and portfolio design.