Conditional Funding Costs of Inflation-Indexed and Conventional Government Bonds

Abstract

This paper employs the predictability of monthly excess returns on U.K. conventional and index-linked gilts to study the risk premiums of nominal and real bonds. The excess return predictions of nominal and real bonds are highly correlated and the restrictions of a single-latent-variable model for expected excess returns are accepted. The estimates of the conditional asset-pricing model reveal that indexed gilts of medium and long maturities require approximately half the risk compensation of conventional gilts. The government can significantly reduce its long run borrowing costs through issuing inflation index-linked debt. However, the inflation indexation of bonds with maturities of up to 3 years does not significantly reduce their risk compensation. The paper also shows that membership in the ERM did not significantly alter the ratio of risk compensation of conventional and indexed gilts.