Asset Allocation with Inflation-Protected Bonds

Article (PDF Available)inFinancial Analysts Journal 60(1) · February 2004with 846 Reads 
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DOI: 10.2469/faj.v60.n1.2592
Cite this publication
Abstract
In the study reported here, we set out to examine whether and how the availability of indexed bonds might affect investors' asset allocation decisions. We used historical yields on conventional U.S. T-bonds and an inflation-forecasting model to create a series of hypothetical indexed bond returns. We found that the real (inflation-adjusted) returns on indexed bonds are less volatile than the returns on otherwise similar conventional bonds. Moreover, the correlation with stock returns is much lower for the indexed bonds. An examination of asset allocation among stocks, indexed bonds, conventional Treasuries, and a riskless asset suggests that substantial weight should be given to indexed bonds in an efficient portfolio. These conclusions are generally supported by analysis of the history of actual returns on U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS) for February 1997 through July 2003.
  • ... For instance, Jarrow and Yildirim (2003) and Chen, Liu, and Cheng (2010) estimate term structure models using TIPS data. Kothari and Shanken (2004), Roll (2004), Huang and Zhong (2010), and Campbell, Shiller, and Viceira (2009) examine diversification benefits of TIPS. The latter two provide further evidence on negative correlations between TIPS and stock returns. ...
  • ... 1 The main advantage of TIPS over nominal Treasuries is that an investor who holds TIPS is hedged against inflation risk. 2 Although there are costs to issuing TIPS (Roush, 2008), there appears to be widespread agreement that the benefits of TIPS outweigh the costs. Campbell, Chan, and Viceira (2003), Kothari and Shanken (2004), Roll (2004), Mamun and Visaltanachoti (2006), Dud- ley, Roush, and Ezer (2009), Barnes, Bodie, Triest, and Wang (2010), Huang and Zhong (2011), and Bekaert and all conclude that TIPS offer significant diversification and hedging benefits to risk averse investors. ...
  • ... which can be evaluated using (28). Combining (39) and (41) gives the result ...
  • ... In this section, we start by explaining the methods to estimate the break-even inflation that we use for our historical simulation of inflation-linked bond returns. We start by explaining the method by Kothari and Shanken (2004). We then describe two alternative models. ...
    Article
    Empirical research on the benefits of investing in inflation-linked bonds usually relies on a limited number of observations due to the relatively recent introduction of these assets. We estimate models for the break-even inflation rate and use these to create hypothetical inflation-linked bond returns. We compare these with the return on actual inflation-linked bond returns on a recent sample and find that surveys of professional forecasters and moving average models perform best. We confirm these findings for a sample of 19 international inflation-linked bond markets. Using surveys of professional forecasters, we create hypothetical inflation-linked bond return series for 41 countries starting in 1987 or later depending on the availability of nominal bond markets. These simulated series can be used by asset allocation researchers, but an average correlation of 0.7 means that the simulated series are at best reasonable proxies for real data on inflation-linked bond returns. This cautionary note is also relevant to appreciate existing research using simulated inflation-linked bond returns.
  • ... The strategic role of inflation-linked bonds therefore differs from that of nominal bonds. Kothari & Shanken (2004) suggest that inflation-linked bonds can enhance the riskreturn tradeoff within a diversified portfolio. Focusing on the US market, they construct a time series of hypothetical inflation-indexed bond returns going back to the 1950s, and show that returns are less volatile than conventional bond returns, and that their correlation with equity returns is lower, thus enabling investors to construct superior mean-variance portfolios. ...
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  • ... The most obvious benefit for investors is inflation protection, which is, for instance, not fully given in nominal bonds (in the case of considerable differences between the expected and realized inflation rate). Furthermore, the presence of inflation-linked securities allows a shift in asset allocation and could lead to better diversification of investors portfolios (see, for instance, Bodie, 1990;Chen and Terrien, 2001;or Kothari and Shanken, 2004). Finally, as discussed extensively in the paper, ILBs are useful for policymakers since their yields can be used to extract market-implied inflation expectations. ...
    Article
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