Static markowitz mean-variance portfolio selection model with long-term bonds

We propose a static Markowitz mean-variance portfolio selection model suitable for long-term zero-coupon bonds. The model uses a multi-factor term structure model of Vasicek (Ornstein-Uhlenbeck) type to compute the portfolio's expected return and its variance in the model. German Government zero-coupon bonds with short to very long time to maturity are considered; the data spans August 2002 to December 2020. The main investment assumption is the re-investment of cash flows of zero-coupon bonds with maturities less than the planning horizon at the current spot interest rate. Solutions for the zero-coupon holding vector and the tangency portfolio are obtained in closed form. Model parameters are estimated under an assumption of modeling ambiguity which takes the form of Knightian uncertainties at the level of the latent factors, allowing the use of a Kalman filter. Different investment strategies are examined on various risk portfolios. Results show that one- and two-factor Vasicek models produce attractive out-of-sample portfolio predictions in terms of the Sharpe ratio especially on long-term investments. It is also noted that a small number of risky bonds can adequately produce very attractive portfolio risk-return profiles.