Forecasting the Term Structure of Interest Rates with SPDE-Based Models

Abstract

The Dynamic Nelson--Siegel (DNS) model is a widely used framework for term structure forecasting. We propose a novel extension that models DNS residuals as a Gaussian random field, capturing dependence across both time and maturity. The residual field is represented via a stochastic partial differential equation (SPDE), enabling flexible covariance structures and scalable Bayesian inference through sparse precision matrices. We consider a range of SPDE specifications, including stationary, non-stationary, anisotropic, and nonseparable models. The SPDE--DNS model is estimated in a Bayesian framework using the integrated nested Laplace approximation (INLA), jointly inferring latent DNS factors and the residual field. Empirical results show that the SPDE-based extensions improve both point and probabilistic forecasts relative to standard benchmarks. When applied in a mean--variance bond portfolio framework, the forecasts generate economically meaningful utility gains, measured as performance fees relative to a Bayesian DNS benchmark under monthly rebalancing. Importantly, incorporating the structured SPDE residual substantially reduces cross-maturity and intertemporal dependence in the remaining measurement error, bringing it closer to white noise. These findings highlight the advantages of combining DNS with SPDE-driven residual modeling for flexible, interpretable, and computationally efficient yield curve forecasting.