Understanding Inflation-Indexed Bond Markets

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Robert T
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Understanding Inflation-Indexed Bond Markets

Post by Robert T »

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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.

...

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.
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rokid
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Post by rokid »

Robert,

Thanks for the post! :D -----Jim
Easy Rhino
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Post by Easy Rhino »

Part got very mathy and nerdy, and I had trouble understanding. But there were a few reasonable tidbits.

1) They hypothesized that the spike in yields in Oct 2008 was due not to any fundamental valuation concerns, but due to the Lehman bankruptcy.

2) They stated that either long nominal gov bonds, or short term t-bills, can sort of deliver a consistent real return, but only if inflation remains stable. Such windows have briefly existed (like during much of the 2000s)
bigH
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Post by bigH »

very interesting paper. I like the graphs that show everything operating within a range until the lehman bankruptcy. crazy black swan
Lauren Vignec
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TIPS

Post by Lauren Vignec »

Hello Robert,

Thank you for posting the paper. I think this part is pretty clear and I took the liberty of highlighting some key words:

This paradigm suggests that the risk premium on TIPS will fall if investors become less concerned about temporary business-cycle shocks, and more concerned about shocks to the long-term consumption growth rate. It is possible that such a shift in investor beliefs did take place during the late 1990's and 2000's, as the Great Moderation mitigated concerns about business-cycle risk while long-term uncertainties about technological progress and climate change became more salient. Of course, the events of 2007-08 have brought business cycle risk to the fore again. The move-ments of inflation-indexed bond yields have been broadly consistent with changing risk perceptions of this sort.

It is a pretty good paper, and this paragraph explains quite nicely why there is so much disagreement about TIPS. Yields on TIPS relative to Treasuries should go up when people are more concerned about business cycle risk; yields on TIPS relative to Treasuries should go down when people are more concerned with consumption shocks like unexpected inflation.

Of course, any given individual might be more (or less) concerned with unexpected inflation than "everyone else", and that individual will not agree with the market's valuation of TIPS. So there are a lot of disagreements about an asset class that seems pretty mild at first glance.

L
peter71
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Post by peter71 »

Hi Robert,

Interesting. I hadn't known that Campbell and Shiller had argued that TIPS were "the" option way back in 1996, and I think that the "we concede nothing" aspect of the paper has to be seen in that light, but I'm glad they're at least addressing the late 2008 issue . . .

All best,
Pete
larryswedroe
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Post by larryswedroe »

Robert
Thanks for posting. Good article. To me only confirms what I have been recommending
peter71
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Post by peter71 »

Larry,

Beware confirmation bias! :D

All best,
Pete
larryswedroe
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Post by larryswedroe »

Peter
Very aware of it, but read their statements. Like TIPS are the safe investment for long-term investors. They did not say either TIPS or ST fixed income are the preferred choice. And they also make the same arguments I have made about 2008 and the financial crisis which forced unusual activity, not only by Lehman which they cited but by others.
peter71
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Post by peter71 »

larryswedroe wrote:Peter
Very aware of it, but read their statements. Like TIPS are the safe investment for long-term investors. They did not say either TIPS or ST fixed income are the preferred choice. And they also make the same arguments I have made about 2008 and the financial crisis which forced unusual activity, not only by Lehman which they cited but by others.
Hi Larry,

My point is simply that some academics love TIPS and some don't. I agree that Campbell and Shiller love them just as much as they did in '96, but, as I said in the other thread, I don't see any evidence for your hasty dismissal of the paper by the academics who don't love TIPS:
larryswedroe wrote: This IMO is classic example of data mining and they even state it.
Here again is the link to the paper for anyone interested . . . I find no references to self-admitted data-mining whatsoever.

http://www.solvay.edu/EN/Research/Bernh ... p07029.pdf

I assure you I don't have anything against TIPS. I'm really only defending the veracity of the old line about economists saying, "on the one hand, on the other hand . . . "

All best,
Pete
Last edited by peter71 on Mon Apr 20, 2009 8:08 pm, edited 1 time in total.
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stratton
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Post by stratton »

peter71 wrote:Here again is the link to the paper for anyone interested . . . I find no references to self-admitted data-mining whatsoever.

http://www.solvay.edu/EN/Resea....p07029.pdf
The URL is broken. "...." is not a valid part of a URL.

Paul
peter71
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Post by peter71 »

Sorry. Still works in the other thread but this time I've copied it directly (will also replace it above):

http://www.solvay.edu/EN/Research/Bernh ... p07029.pdf
peter71
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Post by peter71 »

works now even though it looks the same. the ellipsis is just something that the site is doing.
larryswedroe
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Post by larryswedroe »

Pete
they are now highly correlated with nominal bonds and have reached similar volatility levels. As a result, the two asset classes are practically substitutable. This seems to be due to more stable
inflation expectations and to a more liquid IL bond market
Note the word NOW. We have had a period when we had very stable and low inflation. During such a period we would expect that nominals and TIPS would perform similarly. Believe they even state that. There is certainly no guarantee that this type environment will exist in the future.

That is why I called it data mining, looking only at a very specific period that happens to support a particular conclusion. You buy TIPS to hedge the risks that we will not have stable and low inflation in the future.
peter71
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Post by peter71 »

larryswedroe wrote:Pete
they are now highly correlated with nominal bonds and have reached similar volatility levels. As a result, the two asset classes are practically substitutable. This seems to be due to more stable
inflation expectations and to a more liquid IL bond market
Note the word NOW. We have had a period when we had very stable and low inflation. During such a period we would expect that nominals and TIPS would perform similarly. Believe they even state that. There is certainly no guarantee that this type environment will exist in the future.

That is why I called it data mining, looking only at a very specific period that happens to support a particular conclusion. You buy TIPS to hedge the risks that we will not have stable and low inflation in the future.
Hi Larry,

OK, but their point is that whereas earlier studies of actual TIPS only went from their inception up until 2002 or so, there's extends the sample through 2007. If it turns out 2003-2007 is an atypical historical period and 1997-2002 is a very typical historical period, it may turn out that having more data was a hindrance rather than a help, but that doesn't change the fact that they're analyzing more data.

All best,
Pete
iggyc01
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Re: Understanding Inflation-Indexed Bond Markets

Post by iggyc01 »

The short of how TIPs work is that the principal of the bond is indexed to the Consumer Price Index Non-Seasonally Adjusted (CPI).
If the CPI grows by 1%, my original $1,000 TIPs bond now has a face of $1,010. The fixed coupon is paying off of a higher base, and at maturity you get the current face (not the original) ie $1,010.

The key to understanding TIPs is understanding the concept of "break-evens".
So taking a step back, and very rough example...
Nominal yields = inflation + real-yields.
If a 10yr treasury bond yields 3%, and inflation was 2%, then real yield is 1%.
"Break-evens" is what the TIPs market expects inflation to be over the life for that TIPs bond.

Say on broker screens TIPs are usually quoted at yield to maturity (or real yields). ie 0.50%
If the 10yr TIPs is quoted at 0.50% yield, and the 10yr treasury bond is quoted at 3% yield, then the break-even is 2.5%.
Here is where it matters.
IF CPI YoY inflation is > 2.5% then your TIPs outperforms the same maturity nominal treasury bond.
IF CPI YoY inflation is < 2.5% then your TIPs underperforms the same maturity nominal treasury bond.
IF CPI YoY inflation is = 2.5% then your TIPs is no different the same maturity nominal treasury bond.

So the take-away is that TIPs protects against UNEXPECTED excess inflation as expressed through the CPI.
Typically when traders are trading break-evens they will buy the TIP and short the nominal bond. This way they're only exposed to inflation expectation vs actual inflation. By shorting the nominal bond, they hedge-away interest rate risk. However, for the individual investor, it's more of an opportunity cost. Being long TIPs is like being underweight treasury bonds but with an overweight towards CPI growth.

Whether the CPI truly captures all inflation is another story.
The other thing to take into account, since this is non-core CPI, it includes food & energy, so there is some correlation to oil prices.
Something to consider if allocating to both commodities and TIPs.

References:
https://treasurydirect.gov/indiv/resear ... s_tips.htm
https://www.bls.gov/cpi/
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