The Inflation-Indexed Bond Puzzle

Abstract

This paper presents new insights into the dynamics and determinants of arbitrage mispricing in and across seven of the world’s largest and most liquid financial markets. Specifically, this paper analyzes mispricing between nominal and inflation-linked bonds (ILB mispricing) in the G7 government bond markets, and extends the slow moving capital explanation of the persistence of arbitrage mispricing in financial markets. Nominal bonds are “richer” than cash-flow matched inflation-linked bonds on average. The mispricing is stunning in magnitude: aggregate mispricing is in excess of $22 billion on average during the period from July 2004 to September 2011. In the aftermath of the 2008 financial crisis, it peaks at $101 billion which represents more than eight percent of the total size of the G7 inflation-linked bond markets. Furthermore, the index-linked nominal bond trade generates positively-skewed risk-adjusted excess returns across all countries. The key new insight for the slow-moving capital theory is that capital available to specific types of arbitrageurs is significantly related to the inflation-linked nominal bond mispricing. Specifically, returns of hedge funds following fixed income strategies strongly predict subsequent changes in ILB mispricing, whereas other hedge fund categories lack statistically significant forecasting power. This paper also presents new insights into the effects of monetary policy on arbitrage mispricing. Specifically, during the 2008 financial crisis, central banks around the world may have exacerbated ILB mispricing through large-scale asset purchase programs.