Limits to Arbitrage and Mispricing in TIPS

Abstract

This paper examines limits to arbitrage and mispricing in Treasury protected securities (TIPS). To this end, I construct two different measures of disparity in bond prices from the smooth yield curve. I find that deviations in prices are highly correlated for different maturities and also between nominal Treasury bonds and TIPS. This suggests that arbitrage capital is efficiently allocated across markets and also along the yield curve. I then study the relative mispricing of nominal bonds and TIPS. While flight-to-liquidity explains well the mispricing for nominal bonds it does not for TIPS. In fact, TIPS mispricing is driven by short-term Treasury bond liquidity and the slope of the term structure of expected inflation. Moreover, TIPS mispricing predicts short-term excess returns of TIPS during the crises. This findings can be rationalized with investors who opt for more liquid nominal bonds whenever the short-term expected inflation is very low, i.e. short-term nominal bonds and short-term TIPS are close to perfect substitutes.