Jan

4

Edward Talisse on TIPS

January 4, 2007 |

The inaugural USA Treasury Inflation Protected Security, TIPS 3.375% 1/15/2007, will mature next week on the 15th January 2007. This is an important event and allows us to answer the question “knowing what we know now, was it a good idea to buy TIPS in January 1997, instead of the more widely available nominal bond?” To find out, I did the math (with the help of my colleagues). The answer, although not shocking, reveals quite a bit. Firstly, the nominal bond returned 179.93 per 100 invested. That is an annual return of 6.05%. By comparison, the TIPS bond returned 175.56 per 100 invested. That’s an annual return of 5.79%. During the period, actual annual inflation averaged 2.44%. The TIPS were initially issued at a break even spread of 2.875%, so it’s no surprise that the nominal bond outperformed. In early 1997, the market overestimated expected inflation by a whopping 43 bp on an annualized basis. More interestingly, it only cost and investor 26 bp annualized to buy inflation protection and diversification benefits (6.05% less 5.79%). That seems like a pittance considering what you are getting.

My main conclusions are as follows:

1- Break even inflation expectations are poor predictors of actual inflation, at least by the U.S. example, even considering liquidity and other preferences.

2- another way of looking at it is to say that the market ultimately offered a very generous 43 bp risk premium (term + uncertainty) on nominal bonds back in 1997.

3- From a trading and investment perspective, it seems to make sense to hold your inflation expectations static (say 50 bp in Japan) and vary your risk premium. Right now, the risk premium on nominal Japanese government bonds is slightly less than zero. It’s been as high as +50 bp just six months ago.


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