Investors in TIPS mutual funds who desire real current income
have the option to take the inflation adjustment as a monthly dividend distribution with the tax consequences remaining the same as
with individual TIPS.
4 Therefore, TIPS contain three distinct components of total return—coupon interest, plus inflation adjustment,
plus/minus capital gains/losses. To the extent TIPS minimize the
burden of forecasting inflation and bearing the risk of the inevitable errors in forecasts, they reduce the cost of the government’s
financing because investors do not require the return on these
bonds to cover the risk premium for inflation. On the other hand,
if the government values inflation protection and risk premium no
differently than the investors who price these bonds, TIPS are no
less expensive to the government than conventional bonds.
5 If the
issuers of indexed bonds are more averse to the risk of inflation
than lenders, they may require a premium for issuing such bonds.
In other words, the indexed bonds will carry a negative risk premium for investors should the volatility of inflation be seen as a
concern by the government. In this case, the value of an option
to the insurer would exceed the value of an option to investors.
Nevertheless, it is plausible to assume that governments are at least
less risk-averse than lenders, yielding a positive risk premium for
investors in TIPS. This assumption is based on the belief that the
Treasury can bear the inflation risk better than any particular
investor, because risk is spread across a broad base and Treasury
revenues are correlated with inflation.
Campbell and Viceira (2001) posit that the demand for long-term
bonds is only large when these bonds are indexed or when the
inflation uncertainty is low as it has been in the Volcker-Greenspan
monetary policy regime since 1983. More interestingly, they find
that in a world with full indexation, the unconstrained demand for
both long-term indexed bonds and equities is positive and often
above 100 percent, implying the use of leverage.
6 Moreover, the
Volcker portfolio share of indexed bonds exceeds that of equities.
These analyses indicate that the only investors who lose from
indexation are those with very low risk aversion and who are subject to borrowing and short-sales constraints. So long as the inflation numbers come out greater than the market-driven break-even
inflation, TIPS will continue to outperform nominal Treasuries.
The outperformance of TIPS over the nominal bonds in the recent
past should not be surprising due to the notion that even slightly
higher-than-anticipated (by the market) inflation would result in
the indexed bonds showing better returns that the nominal coun-
terparts of identical maturity. Nevertheless, one should remember
the period between May and November 2013, when the ten largest
inflation-indexed mutual funds lost 36 percent of their assets as
inflation-linked bonds plunged about 9 percent during the year.
The volatility of individual issues of TIPS has been three times
higher than that of the Barclays U.S. Aggregate Bond Index. Thus,
betting on the direction of TIPS prices could prove to be quite
challenging, as former PIMCO boss Bill Gross learned a tough les-
son (Weiss and Leondis 2013). We believe it is crucial to decipher
the sources of return in nominal versus inflation-linked securities
to better align the risk budgeting within strategic asset allocation.
To this end, table 1 illustrates the differences between the compo-
nents of yields on nominal and inflation-indexed bonds issued by
the U.S. Treasury.
Investors must understand various risk premia related to the spe-
cific design of inflation-linked bonds so they can be properly com-
pensated for the unique risks associated with TIPS due to issues
such as the following:
• Imperfect indexation, which could lead to three forms of basis
risk, which reflects the possibility that TIPS is an imperfect hedge.
» CPI may be a bad proxy for certain investors.
» The method of calculating the CPI can be altered to the
detriment of a TIPS investor.
» Two-month lag between the public announcement of CPI
and the corresponding adjustment in the face value of TIPS.
• Premium for giving up high payoffs under deflation.
• Premium for giving up smaller capital losses when real
As insurance companies increase the number of real annuity
offerings to retirees, they will begin to hedge these exposures by
purchasing TIPS of different maturities. Brown et al. (2002) find
that the willingness to pay for real annuities is positive, but modest,
under the following conditions: ( 1) median levels of risk aversion,
( 2) persistent inflation process, and ( 3) pre-existing real annuity
Table 1: Breakdown of Components of Government Bond Yields
Real interest rate Yes Yes
Compensation for expected inflation Yes No
Illiquidity premium* No Yes
Compensation for inflation risk Yes No
Compensation for risks uniquely associated with TIPS No Yes
Fleming and Krishnan (2012), using novel tick data from the interdealer market, provides new evidence on the liquidity of inflation-linked bonds and how their liquidity differs from
that of nominal securities. Analysis of various liquidity measures suggests that trading activity and the incidence of posted quotes may be better cross-sectional gauges of TIPS
liquidity than bid-ask spreads or quoted depth. Differences in intraday trading patterns and announcement effects between TIPS and nominal securities likely reflect the different
use, ownership, and cash-flow attributes of the securities. D’Amico et al. (2008) estimate that the liquidity premium was about 1 percent in the early years of the TIPS program.
Pflueger and Viceira (2011) find that the liquidity premium is around 40 to 70 basis points during normal times, but was more during the early years of TIPS and during the 2008