HOFIS 18 - Inflation Protection Securities Flashcards
Overview of Inflation Linked Bonds
- Principal is indexed to CPI, so real yield is fixed
- Nominal yield floats with inflation
- TIPS Coupon = (Coupon Rate) x (CPI-Adjusted Principal)
- CPI adjustment for current month t: Principalt = Principalt-1 X CPIt-3/CPIt-4 (yoy change t-3 is 3 month lag but t-4 is one year prior to t-3)
- Adjusted principal will rise with inflation and fall with deflation
- Maturity value is floored at initial principal (unique to TIPS)
- Off-coupon-date settlement value can be calculated by linearly interpolating value using a 30-day-month
Benefits of TIPS
- An inflation hedge
- Low correlation with other asset classes
Definition of Real yield fo TIPS and when can it be calculated?
- Annualized growth rate of purchasing power
- Real yield of a nominal bond can only be calculated in hindsight when inflation is known
TIPS Nominal Yield Formula
(1 + real yieldq) x (1 + inflationq ) - 1
TIPS Break-Even Vs Risk-adjusted Break-Even
Inflation Rate.
- Break-even inflation rate results in the holder of a TIPS having the same yield as the holder of a nominal bond
- (1 + conventional nominal yield) / (1 + TIPS real yield) - 1
- The risk-adjusted break-even equals the break-even inflation rate minus an
inflation risk premium- Break-even rate - inflation risk premium
- Conventional (nominal) yield includes inflation risk premium, at least part of
which is not included in TIPS real yield.
Describe TIPS Duration
- TIPS Inflation duration = 0
- TIPS effective (nominal) duration = 75% x Real Duration (estimate crude approach that doesn’t always hold up in practice)
- TIPS real duration (see formula in image)
- Real and effective durations are not perfectly correlated
TIPS liquidity
Less liquid than treasuries, more liquid than corporate bonds, sturctured fixed income securities, and other inflation hedges (real estate, etc)
Taylor Rule for Real Yields
The Taylor rule argues over time the real fed funds rate should equal the long-term real economic growth rate of the economy
Investors’ Uses of Inflation Linked Bonds
- Tactical uses
- Strategic (goal-oriented) uses
- ALM and surplus management (can focus on suplus managment)
- Risk/return optimization (must know TIPS correlations)
- Managing dedicated TIPS portfolios
- Investor-specific (Pensions, endowments/foundations, old people)
Tactical Uses of Inflation Linked Bonds
- Trade with respect to similar non-TIPS bonds
- Trading international inflation-linked bonds (International Relative Value Opportunities)
Strategic (goal oriented) Uses of Inflation Linked Bonds
- Increase returns from cash
- Decrease risk from classes such as equities and real estate (diversification)
- Match liabilities (e.g., for pension funds)
TIPS Break-even strategies
Involve holding TIPS and selling similar Treasuries; nullifie the real yield of TIPS and leaves inflation protection only.
Issuers of Inflation Linked Bonds
- U.S. Treasury (biggest)
- Management of average maturity of outstanding debt
- Market-based inflation forecasts
- Jives well with U.S. Treasury’s ability to tax
- International issuers
- Corporations, agencies, and municipalities (corps, agencies adjust coupons, not principal)
Moral Hazard of US Treasury to issue TIPS
The government ultimately controls the real value of its debt because it also publishes CPI.
- Several factors mitigate the risk of moral hazard:
- Moral hazard is minimal because of:
- Professional integrity
- Strong institutional structure
- Political pressure
- Risk of credibility loss, default perception
TIPS Deflation Protection
TIPS are guaranteed to mature for at least their original principal amount
