Forecasting the term structures of Treasury and corporate yields using dynamic Nelson‐Siegel models

We extend Diebold and Li’s dynamic Nelson‐Siegel three‐factor model to a broader empirical prospective by including the evaluation of the state space approach and by using nine different ratings for corporate bonds. We find that the dynamic Nelson‐Siegel factor AR(1) model outperforms other competitors on the out‐of‐sample forecast accuracy, especially on the investment‐grade bonds for the short‐term forecast horizon and on the high‐yield bonds for the long‐term forecast horizon. The dynamic Nelson‐Siegel factor state space model, however, becomes appealing on the high‐yield bonds in the short‐term forecast horizon, where the factor dynamics are more likely time‐varying and parameter instability is more probable in the model specification.