Forecasting a Yield
Forecasting the yield on a given asset class is possibly one of the most difficult things to do when deciding where and when to invest.
Economists evaluate economic date to decide whether or not Treasury bond yields will rise or fall (as well as what the shape of the yield curve will be).
Corporate bond analysts scour balance sheets and other financial information to decide if a company’s cost of borrowing will rise or fall.
Treasurers analyze swap rates to determine if they should swap their fixed interest rate exposure to floating rate exposure if interest rates are set to decline. The list of analysts and investors who can benefit from successful interest rate forecasting is endless. Forecasts of yields on Treasuries, mortgage backed securities and corporate bonds are relatively easy to find. The Federal Reserve, the Department of the Treasury, Fannie Mae, Freddie Mac and numerous banks and brokerages publish their forecasts of yields. The one problem is: they often don't explain how they came up with their forecast.
What's behind the interest rate forecast
The Yield Model, a newly created approach by Michael Brennan (MS Finance), proposes a series of steps one should take to derive such forecasts. Usually this starts by outlining the hypotheses as to which financial and economic time series drive a given yield. Subsequently those time series are regressed against the rate to forecast.
From here each regression is evaluated using different statistical techniques to determine if the obtained results are valid and if the relationships between the chosen variables will continue to hold in the future. A set of appropriate statistical tests is applied to extrapolate the independent variables in order to forecast various interest rates. Once such rates are forecast, investors can make an educated decision as to which sectors of the bond market they want to have the largest allocation to, whether they want to have a higher exposure to higher or lower quality bonds and what they want the maturity structure of their portfolio to be.
The Yield Model is unique in that it not only forecasts the interest rates that are most useful to investors, but educates investors as to how we develop their forecasts.