HOFIS Ch15 Flashcards
(5 cards)
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
