Understanding Inflation-Indexed Bond Markets
.What lessons should investors learn from the history of TIPS and inflation-indexed gilt yields?
The basic case for inflation-indexed bonds ... is that these bonds are the safe asset for long-term investors. An inflation-indexed perpetuity delivers a known stream of real spending power to an infinite-lived investor, and a zero-coupon inflation-indexed bond delivers a known real payment in the distant future to an investor who values wealth at that single horizon. This argument does not make any assumption about the time-series variation in yields, and so it is not invalidated by the gradual long-term decline in inflation-indexed bond yields since the 1990s, the mysterious medium-run variations in TIPS yields relative to short-term real interest rates, the spike in yields in the fall of 2008, or the high daily volatility of TIPS returns.
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A simple quantitative measure of the usefulness of inflation-indexed bonds is the reduction in portfolio standard deviation that it enables long-term investors to achieve. We can estimate this reduction by calculating the long-run standard deviation of a portfolio of other assets chosen to minimize long-run risk. Since inflation-indexed bonds have zero long-run risk, the minimum alternative standard deviation measures the risk reduction that inflation-indexed bonds make possible.