In this paper we develop and estimate an arbitrage-free multi-factor
two-country affine term structure model to investigate the time-series
dynamics and determinants of international diversification gains for bonds
of different maturities. The model is built upon two novel features:
macro-economic factors and regime shifts in the loadings and market prices
of factors. We decompose the macro factors and latent state variables into
common and local factors, and allow the term structure dynamics to switch
over time among four distinct regimes. The most general model in our class,
and several special cases of the general model, are each estimated by a
carefully articulated Bayesian method. Estimation results on yield curve
data for the U.S. and Canada reveal that the conditional correlation between
cross-country bond returns is increasing with time to maturity. Moreover,
the conditional correlation for shorter maturities varies more dramatically,
driven by business cycles asymmetries between the countries. These findings
imply that an internationally diversified portfolio of short-term bonds
provides a good hedge against large declines in the domestic bond market,
and that the expected gains from international diversification are maximized
when the business cycles of the countries are misaligned.