rising liquidity of the TIPS market. Using a vector autoregressive
(VAR) time-series model, they investigate the optimal strategic
asset allocation for investors seeking to hedge inflation risk in two
different macroeconomic regimes. In the volatile macroeconomic
environment marked by countercyclical supply shocks, cash,
inflation-indexed bonds, and precious metals play an essential role;
in the more stable macroeconomic environment with pro-cyclical
demand shocks, cash and nominal bonds play the most significant
role, followed by precious metals, real estate, and equities.
Attie and Roache (2009) estimates a multivariate vector error correction model to calculate impulse responses to assess the short- and
long-run dynamic impact of inflation shocks. They conclude that
among traditional asset classes, inflation hedges are imperfect at best
and unlikely to work at worst. Nevertheless the paper postulates that
there is scope to enhance inflation protection through tactical asset
allocation; e.g., by tilting the portfolio toward commodities and away
from bonds in the aftermath of a positive inflation shock.
Xu (2011) examines comparative performances of inflation-indexed
and nominal bonds by using a structural VAR model and finds that
nominal bonds tend to outperform TIPS during periods dominated
by increasing concern for credit and liquidity risks, whereas TIPS
tend to outperform during highly inflationary environments.
Finally, Amenc et al. (2009) suggests that for long-term investors
facing inflation-related liability constraints, a liability-hedging
portfolio of commodities, real estate, and TIPS could result in
decreasing the cost of inflation insurance.
Security Characteristics of Inflation-Linked Bonds
Treasury inflation-indexed securities are U.S. Treasury-issued notes
and bonds famously known by investors as TIPS due to their ear-
lier name, Treasury inflation-protected securities. Their principal
value is adjusted monthly for changes in the level of inflation as
measured by the non-seasonally-adjusted Consumer Price Index
for All Urban Consumers on a two-month lag. Inflation-indexed
bonds were created to meet the needs of longer-term investors
wanting to insulate investment principal from erosion due to infla-
tion. These bonds have been issued in the United Kingdom (1981),
Australia (1985), Canada (1991), the United States (1997), and
France (1998). Since February 1997, the U.S. Department of the
Treasury issued a total of fifty-six issues of Treasury inflation-
indexed securities (with an outstanding total of $1.293 trillion)
until March 2015, seventeen of which have matured with an out-
standing total of $291 billion. Hence thirty-nine issues are out-
standing with a total value of about $1 trillion.
1 The Treasury issues
TIPS with original maturities of five, ten, and thirty years. New
five-year notes are issued once a year in April and then re-opened
in August and December.
2 New ten-year notes are issued in
January and July; the January notes are re-opened in March and
May and the July notes in September and November. New thirty-
year bonds are issued in February and re-opened in June and
October. Twenty-year bonds are not issued currently, but five of
those were auctioned between July 2004 and January 2009.
Furthermore, on October 31, 2001, the Treasury announced the
suspension of both thirty-year TIPS and nominal thirty-year
Treasury bond issuance but started re-issuing in February 2010.
The suspension in 2001 was mainly due to growing budget sur-
pluses, a very steep yield curve,
3 and the government’s desire to pay
down the federal debt. Since 2006, the sequence of TIPS issuance
has been quite clear. Until the suspension of twenty-year bonds, the
sequence was ten, twenty, five, and ten between January and July of
every year. Afterward, when the Treasury decided to re-issue the
thirty-year bonds to replace the twenty-year bonds in 2010, the
sequence turned into ten, thirty, five, and ten. We will analyze how
the suspension and re-issuing of thirty-year TIPS affected the
diversification and hedging benefits of these securities in a separate
paper. In particular, we will look into whether the correlation
dynamics between TIPS and other asset classes changed after the
suspension in 2001 and the re-issuance in 2010.
The basic structure is the same for all TIPS. A fixed-coupon interest rate is paid semi-annually on the inflation-adjusted principal.
At maturity, the principal is redeemed at the inflation-adjusted
principal amount (but not less than par value). In other words,
unlike the Canadian counterparts, TIPS issued in the United States
are protected against the risk of deflation. The U.S. Department of
the Treasury provides a guarantee (i.e., a floor) at the par value in a
deflationary environment. As a result of this guaranteed principal
floor, TIPS incorporate a minimal hedge against sustained deflation, acting as a deflation put. In the event of an absolute decline in
the price level, i.e., deflation over the life of an inflation-protected
bond, the Treasury will repay the full face value at maturity, insuring a floor for investors. That is, the principal of TIPS is increased
by the percentage increase in the CPI or decreased by the percentage decrease in the CPI unless such adjustment would reduce the
principal below its initial value.
This asymmetric price-level adjustment feature provides TIPS
investors with some protection against deflation in addition to
complete inflation protection. An increase in inflation results
in a commensurate increase in outstanding principal payable
to the TIPS bondholder at maturity. In mutual funds holding
inflation-protected securities, the inflation adjustment to principal
is accrued as current income and allocated to shareholders.
To protect their purchasing power over time, mutual fund investors must reinvest at least the inflation-adjustment portion of the
distribution. In other words, investors who spend, rather than
reinvest, their entire distribution will defeat the inflation-protection
purpose of this fund. Like all Treasuries, the interest income on
TIPS is subject to federal income tax, but it is exempt from state
and local taxes. The principal inflation adjustment on TIPS
is also taxed as ordinary interest income in the year in which
the adjustments occur, even though investors will receive no
cash from the principal adjustment until maturity or when sold,
similar to the imputed (i.e., phantom) income derived from