witnessed over the past decade in realized year-over-year inflation,
it is only prudent to understand the benefits and risks of TIPS
during different periods of the inflationary regime, i.e., inflation,
disinflation, and deflation.
Specifically, this paper examines risk/return profiles of inflation-linked bonds in the United States between 1997 and 2015 to determine how indexed bonds can be utilized within the context of strategic asset allocation. This study explores the question of whether TIPS
improve the portfolio efficiency of investors by providing favorable
correlation structure with other asset classes, and thus, improving
Sharpe ratios of investment portfolios. Furthermore, it attempts to
answer the question of TIPS being assigned a separate asset-class
status next to stocks, bonds, commodities, real estate, and foreign
exchange. We will show whether TIPS can replace an equal portion
of all other asset classes or a portion of conventional bonds, as suggested in the literature. Our postulate is that TIPS by definition are
more suitable than other asset classes in the real-assets bucket and
deserve a separate spot in the strategic asset allocation process.
Several scholars have studied the relationship between TIPS and
conventional nominal bonds. Hunter and Simon (2005) examines
the relationship between TIPS and nominal bonds using weekly data
from February 1997 to August 2001, using a bivariate GARCH
framework to model the conditional means and volatilities as well as
their conditional correlation. Their research concluded that adding
TIPS to a portfolio of Treasury bills, nominal bonds, and equities
does not significantly enhance the opportunity set for investors.
However, because the inflation during the sample period remained
relatively low, we would argue that extending the data period to
include a full business cycle might shed more light on the benefits of
TIPS in building more-efficient portfolios with higher Sharpe ratios.
Cartea et al. (2012) draws a distinction between buy-and-hold long-term and short-term investors to show that each type benefits differently from the use of TIPS in their portfolios. Specifically, TIPS
replace nominal risk-free assets for long-term investors, and
improve the opportunity set of real returns for short-term investors.
They further show that gains from TIPS are tempered by the availability of such alternative assets as gold and real estate, both of
which co-vary with inflation. Moreover, they postulate that when
commodities are available, the improvement to highly risk-averse
investors decreases due to the fact that commodities represent a better hedge against inflation. Their analysis did not include any rebalancing between different asset classes at intermediate points in time.
Daskalaki and Skiadopoulos (2011) investigates whether investors
are better off adding commodities to a portfolio with traditional
asset classes, namely stocks, bonds, and cash. They depart from
previous research by employing mean-variance and non-mean-variance spanning tests and then forming optimal portfolios by
taking into account the higher order moments of the portfolio
returns distribution and evaluating out-of-sample performance.
Their conclusion challenges the alleged diversification benefits of
commodities and their evidence is robust across a number of performance evaluation measures, utility functions, and datasets.
However, they note an exception during the 2005–2008 unprecedented boom period for commodities.
Chu et al. (2007) investigates whether the inflation protection
offered by TIPS occurs in real time, with TIPS prices moving up
and down to reflect the flow of consumer price index (CPI) information into the market before the CPI announcement, or whether
the price adjustment occurs only on or after the monthly public
announcement. This is a crucial point for our purposes because we
analyze diversification benefits of TIPS and also entertain the idea
of using them within the real-assets subportfolio, which has been
gaining popularity as part of the portfolio construction process.
Using pooled time-series cross-sectional data, the study shows that
TIPS prices efficiently aggregate near-term inflation information.
Their conclusion is that the market is very efficient in observing
and responding to changes in consumer prices as they occur. They
also postulate that TIPS prices were distorted before 2004 due to
the presence of a significant liquidity premium.
Christensen and Gillan (2011) argues that estimating market
expectations for inflation from the yield difference between nominal Treasuries and TIPS is complicated by the liquidity differential
between these two types of securities. They show that until the failure of Lehman Brothers, the yield spread between seasoned and
newly issued TIPS of comparable maturities was typically negative
because deflation risk was negligible. However, in the weeks and
months following the Lehman failure, a significant and persistent
spread reflected widespread deflation fears.
In an attempt to find the assets that hedge against inflation most
effectively, Bruno and Chincarini (2011) concludes that TIPS are
only slightly effective for protecting against inflation conditional on
an investor using a specific group of asset classes. The study found
the best allocation to consist of some combination of Treasury bills,
government bonds, gold, oil, and emerging market equities.
Regarding inflation-linked bonds, the authors argue that inflation-linked bonds seem to be less important within the context of asset
allocation due to higher volatility.
However, Illeditsch (2009) proposes to replace nominal bonds completely by inflation-linked bonds because the combination of stocks,
other real assets, and TIPS could be optimal from a risk standpoint.
Krämer (2015) shows that particularly in periods of stagflation, only
inflation-linked bonds offer optimal protection against inflation. He
further argues that TIPS historically have a low correlation to stocks
and traditional bonds over the long term as a result of the behavior
of these asset classes in periods of real growth and inflation.
Nevertheless, Briere and Signori (2012) notes that the diversification benefit of inflation-linked bonds is getting smaller due to the