Overseas unspanned factors and domestic bond returns

Using data on government bond yields in Germany and the United States, we show that overseas unspanned factors — constructed from the components of overseas yields that are uncorrelated with domestic yields — have significant explanatory power for subsequent domestic bond returns. This result is remarkably robust, holding for different sample periods, as well as out of sample. Shocks to overseas unspanned factors have large and persistent effects on domestic yield curves. Dynamic term structure models that omit information about foreign bond yields are therefore likely to be misspecified.