HOFIS Ch15 Flashcards
Overview of Inflation Linked Bonds
Principal is indexed to CPI, so real yield is fixed
An inflation hedge
Low correlation with other asset classes
TIPS Coupon = (Coupon Rate) (CPI-Adjusted Principal)
CPI adjustment for current month t:
Principalt Principalt1
CPIt3
CPIt4
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
State the TIPS Nominal Yield and Break-Even Inflation Rate Formulas
TIPS nominal yield can only be calculated in hindsight:
p1 real yieldq p1 inflationq 1
Break-even inflation rate:
1 conventional nominal yield
1 TIPS real yield 1
Describe TIPS Duration
TIPS Inflation Duration = 0
TIPS real duration:
Duration 100 rMV(real yield - 0.50%) MV(real yield + 0.50%)s{MV(real yield)
TIPS Nominal Duration = 75% Real Duration
Investors’ Uses of Inflation Linked Bonds
- Tactical uses
Trade with respect to similar non-TIPS bonds
Trading international inflation-linked bonds - Strategic (goal-oriented) uses
Increase cash returns
Diversify away from equities and real estate
Matching liabilities - ALM and surplus management
- Risk/return optimization
- Managing dedicated TIPS portfolios
Passive vs. active
Buy TIPS, sell similar Treasuries - Investor-specific
Pensions, endowments/foundations, old people
State and Describe the 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
Moral hazard is minimal because of
Professional integrity
Strong institutional structure
Political pressure
Risk of credibility loss, default perception - International issuers
- Corporations, agencies, and municipalities
