Shrinking the Term Structure

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 correspond to the optimal non-parametric basis functions spanning the discount curve. They are investable portfolios estimated with cross-sectional ridge regressions and derived from economic first principles. Empirically, we show that four factors explain the discount bond excess return curve and term structure premium. Cash flows are covariances, as cash flows of coupon bonds fully explain the factor exposure. The term structure premium depends on the market complexity measured by the time-varying importance of higher order factors