Dynamic Bond Portfolio Choice with Macroeconomic Information

Abstract

This study examines the optimal portfolio choice of a long-term bond investor, who faces a set of macroeconomic risk factors, both observable (inflation and output gap) and latent ones (real interest rate, inflation central tendency and real interest rate central tendency). It makes use of the essentially affine macro-finance term structure model of Dewachter, Lyrio and Maes (2006) that allows for time-varying risk premia, capturing the failure of the expectations hypothesis. Employing this setup, the investment as well as the hedging opportunities provided by consistently priced zero-coupon bonds for a power utility agent are examined. Moreover, real bonds are introduced and their role for investment and hedging purposes is considered. This study also serves as an evaluation of the employed macro-finance term structure model from an asset allocation perspective, revealing that more attention should be paid to the covariance structure of the bonds' returns.