Parsimonious modeling and forecasting of corporate yield curve

This paper investigates the sensitivity of out‐of‐sample forecasting performance over a span of different parameters of l in the dynamic Nelson–Siegel three‐factor AR(1) model. First, we find that the ad hoc selection of l is not optimal. Second, we find a substantial difference in factor dynamics between investment‐grade and speculative‐grade corporate bonds from 1994:12 to 2006: 4. Third, we suggest that the three‐factor model is sufficient to explain the main variations of corporate yield changes. Finally, the parsimonious Nelson–Siegel three‐factor AR(1) model remains competitive in the out‐of‐sample forecasting of corporate yields. Copyright © 2008 John Wiley & Sons, Ltd.