Treasury Inflation-Protected Securities Research Articles

The Impact of Inflation on Institutional Investors' Behaviour in the Indian Stock Market

Inflation has a significant impact on equity markets as it can lead to a reduction in purchasing power and a reduction in real income, which in turn affects the cost of equity. While inflation generally has a negative impact on equity markets, it can have a positive effect in some cases. Investors in the Indian stock market can react to inflation by adapting their investment strategies, including changes in asset allocation, sector rotation, risk management, monitoring central banks ‘activities and adjusting their investment horizon. Institutional Investors (IIs), such as pension funds, insurance companies and mutual funds, may adjust their investment strategies in order to include more inflation-linked assets, such as Treasury Inflation-Protected Securities (TIPS) or inflation-indexed bonds, in order to preserve their purchasing power. In addition, their portfolios can be reallocated to assets less susceptible to the negative effects of inflation, such as equities, gold and real estate. Institutional Investors can also move their investments to sectors that tend to perform well during inflationary periods, such as consumer staples, utilities and natural resources. In addition, risk management strategies, such as diversification, hedging, or investment in inflation-protected securities, may be used to protect portfolios from inflation-induced volatility. Finally, Institutional Investors closely monitor the central bank's activities, such as interest rates of the Reserve Bank of India (RBI) and monetary policy adjustments, which may affect inflationary expectations and market sentiment. This study aims to analyse the impact of inflation on Institutional Investors’(IIs) investment behaviour in the Indian stock market.

What drives the TIPS–Treasury bond mispricing?

Inflation-swapped Treasury Inflation-Protected Securities (TIPS) are usually undervalued compared to cash flow-matched Treasury bonds. From 2005 to 2022, TIPS discounts are persistent, averaging approximately 3.18 % of the face value, with a peak of 16.10 %. We elucidate the factors associated with this persistent mispricing and the extent of this association. The results from feature selection techniques and the variable importance-in-projection method reveal that marking-to-market concerns and intermediation frictions are key to understanding the underpricing of TIPS relative to comparable nominal Treasury securities. We conclude that when strategic concerns overwhelm fundamental analysis, asset prices could deviate from fundamental values over a prolonged period.

What Do TIPS Say about Real Interest Rates and Required Returns?

An arbitrage-free model decomposes yields on Treasury Inflation-Protected Securities (TIPS) into expected real rates, real frictionless term premiums, and liquidity premiums. Estimation eschews non-market information, incorporates a novel observable liquidity factor, and addresses factor persistence and sample biases, including real-time estimation. Results include a modest secular decline in equilibrium real rates and a much larger drop in frictionless required excess real returns, on net, from July 1999 to September 2022. Real term premiums appear to be pro-cyclical, which implies that the default risk-free asset is a hedge, and some evidence suggests that TIPS liquidity premiums are counter-cyclical.

The changing landscape of treasury auctions

Contemporary literature attributes the temporary drop in secondary prices before a Treasury auction to primary dealers’ limited risk-bearing capacity and slow-moving capital. We attribute the temporary price pressure to slow-moving capital, but not primary dealer’s limited risk-bearing capacity. We document a decline of more than 45% in the Treasury Inflation-Protected Securities (TIPS) auction amount allocated to primary dealers over the years and uncover empirical evidence inconsistent with dealers being the main contributor to the auction cycle. In contrast, our results suggest strategic trading behavior whereby some direct and indirect bidders deliberately reduce their demand in the days leading to the auction. More specifically, we find that, on average, inflows into inflation-indexed mutual funds before the auction days do not translate into increased demand for the underlying, as opposed to inflows on other days. Our results imply an issuance cost to the US Treasury of over $300 million for issuing TIPS in 2019 alone.

Can treasury inflation-protected securities safeguard investors from outward risk spillovers? A portfolio hedging strategy through the prism of COVID-19

Documenting the interlinkages among assets that are widely used to hedge against inflation is crucial for investors, as the necessity to protect the investment portfolio is stronger under inflationary conditions. For this purpose, we investigate the volatility spillovers between treasury inflation-protected securities (TIPS) and a battery of other assets perceived as inflation hedges, including bonds, gold, real estate, oil and equities. The applied methodology comprehends the time-varying parameter vector autoregressive (TVP-VAR) extension of the Diebold and Yilmaz (Int J Forecast 28:57–66, 2012, 10.1016/j.ijforecast.2011.02.006) approach for the period 1/1/2010–3/31/2022. Our results indicate that the assets under consideration are moderately interconnected and subjected to several exogenous shocks, such as the US–China trade war, the COVID-19 pandemic and the Russia–Ukraine war. Furthermore, we assess the hedging effectiveness of TIPS against each asset by estimating hedge ratios and optimal portfolios weights, before and after the spread of COVID-19 pandemic, by using conditional variance estimations (DCC-GARCH). The empirical findings show that the short position in the volatility of TIPS is proved to be an excellent hedge for all the sampled assets, with the exception of short-term Treasury bonds, and their hedging ability was improved during COVID-19.

Money Illusion and TIPS Demand

AbstractThe market demand for the Treasury Inflation‐Protected Securities (TIPS) is rather small. This is puzzling, as we show that an agent, who derives utility from real wealth and dynamically invests into multiple asset classes over a 30‐year horizon, incurs a certainty equivalent loss of 1.6% per annum from not investing in inflation‐indexed bonds. However, if the investor suffers from money illusion, the perceived loss is only 0.5% per annum. Furthermore, the perceived loss is totally negligible for an unsophisticated money‐illusioned investor ignoring the time variation of risk premia. Money illusion causes significant portfolio shifts from inflation‐indexed toward nominal bonds, with little effects on equity allocations, contributing to the low market demand for TIPS.

Does quantitative easing affect market liquidity?

We argue that central bank large-scale asset purchases—commonly known as quantitative easing (QE)—can reduce priced frictions to trading through a liquidity channel that operates by temporarily increasing the bargaining power of sellers in the market for the targeted securities. For evidence we analyze how the Federal Reserve’s second QE program that included purchases of Treasury inflation-protected securities (TIPS) affected a measure of liquidity premiums in TIPS yields and inflation swap rates. We find that, for the duration of the program, the liquidity premium measure averaged about 10 basis points lower than expected. This suggests that QE can improve market liquidity.

The TIPS Liquidity Premium

Abstract We introduce an arbitrage-free term structure model of nominal and real yields that accounts for liquidity risk in Treasury inflation-protected securities (TIPS). The novel feature of our model is to identify liquidity risk from individual TIPS prices by accounting for the tendency that TIPS, like most fixed-income securities, go into buy-and-hold investors’ portfolios as time passes. We find a sizable and countercyclical TIPS liquidity premium, which helps our model to match TIPS prices. Accounting for liquidity risk also improves the model’s ability to forecast inflation and match surveys of inflation expectations.

The Increased Toxicity of the U.S. Treasury Security Market

This short research paper documents the fact that exclusively watching for rising yields on conventional U.S. Treasury securities to reflect increased inflationary fears in the U.S. is no longer appropriate. With the Federal Reserve seeking to keep short-term nominal yields near zero for an extended period, conventional Treasury yields have not shown the full extent of rising fears of inflation in financial markets. In this monetary environment, the yields on Treasury Inflation Protected Securities (TIPS) have been more reflective of rising inflation fears. TIPS yields have become increasingly negative in absolute terms during the latter part of 2020. The negative yields on TIPS further suggests that all Treasury investors should be expecting lost purchasing power when they hold onto such securities.

Inflation Expectations in the U.S.

Inflation has been below the Federal Reserve’s target for much of the past 20 years, creating worries that inflation may be deanchoring from the FOMC’s target. This paper uses a factor model that incorporates information from professional forecasters, household and business surveys, and the market for Treasury inflation protected securities (TIPS) to estimate long-run inflation expectations. These have fallen notably in the past few years (to roughly 1.9 percent for CPI inflation, well below the FOMC’s target). It appears that, even before the covid recession, the private sector viewed the economy as likely to suffer from persistent headwinds to inflation.

The TIPS Liquidity Premium

We introduce an arbitrage-free term structure model of nominal and real yields that accounts for liquidity risk in Treasury inflation-protected securities (TIPS). The novel feature of our model is to identify liquidity risk from individual TIPS prices by accounting for the tendency that TIPS, like most fixed-income securities, go into buy-and-hold investors’ portfolios as time passes. We find a sizable and countercyclical TIPS liquidity premium, which helps our model to match TIPS prices. Accounting for liquidity risk also improves the model’s ability to forecast inflation and match surveys of inflation expectations, although these series are not included in the estimation.

Is There an On-the-Run Premium in TIPS?

In the U.S. Treasury market, the most recently issued, or so-called “on-the-run,” security typically trades at a price above those of more seasoned but otherwise comparable securities. This difference is known as the on-the-run premium. In this paper, yield spreads between pairs of Treasury Inflation-Protected Securities (TIPS) with both matching and nearly-matching maturities but of separate vintages are analyzed. Adjusting for differences in conventional liquidity premiums, values of embedded deflation options, and coupon rates, the results show a small, insignificant premium on recently issued TIPS, which leads us to conclude that there is no on-the-run premium in the TIPS market.

The Changing Landscape of Treasury Auctions

Recent literature attributes the temporary drop in secondary Treasury prices before a Treasury auction to primary dealers’ limited risk-bearing capacity. However, we document a decline of more than 45% in the Treasury Inflation-Protected Securities (TIPS) auction amount allocated to dealers over the years, without any apparent decline in temporary price pressure. We show that dealers are mostly active in the inflation-derivatives market rather than the TIPS market. We attribute the temporary price pressure to slow-moving capital, and we find evidence of strategic trading where some direct and indirect bidders deliberately reduce their demand in the days leading to the auction. More specifically, we find that, on average, an inflow in an inflation-indexed mutual fund before the auction days does not translate into increased demand for the underlying, as opposed to inflows other than surrounding the auction days. Our results imply a large issuance cost for TIPS to the US Treasury.

Inflation Expectations in the U.S.: Linking Markets, Households, and Businesses

Inflation has been below the Federal Reserve's target for much of the past 20 years, creating worries that inflation may be deanchoring from the FOMC's target. This paper uses a factor model that incorporates information from professional forecasters, household and business surveys, and the market for Treasury inflation protected securities (TIPS) to estimate long-run inflation expectations. These have fallen notably in the past few years (to roughly 1.9 percent for CPI inflation, well below the FOMC's target). It appears that, even before the covid recession, the private sector viewed the economy as likely to suffer from persistent headwinds to inflation.

The Term Structure of Mutual Fund Herding

This paper investigates herding behaviors in U.S treasury markets. We document novel evidence that mutual funds exhibit strong herding behaviors on trading long-term treasuries. This “term-structure” herding is only pronounced for buy herding, not sell herding. The relationship between herding and time-to-maturity is stronger for funds with high fund flow volatility. Such behaviors also exist for Treasury Inflation Protected Securities (TIPS) and for treasuries with both high and low coupon rates, suggesting that herding is not driven by correlated inflation expectations. Similar results are obtained for investment-grade corporate bonds as well. Overall, our results suggest that mutual funds’ short investment horizons contribute to the term-structure herding behaviors in the bond markets.

Term Structures of Inflation Expectations and Real Interest Rates

I use a statistical model to combine various surveys to produce a term structure of inflation expectations—inflation expectations at any horizon—and an associated term structure of real interest rates. Inflation expectations extracted from this model track realized inflation quite well, and in terms of forecast accuracy, they are at par with or superior to some popular alternatives. The real interest rates obtained from the model follow Treasury Inflation-Protected Securities rates as well.

The Pre-FOMC Announcement Drift: An Empirical Analysis

Previous research documented large positive abnormal returns in US equity markets during a 24-hour window immediately preceding Federal Open Market Committee (FOMC) meetings between 1994 and 2011. This anomaly was called the “pre-FOMC announcement drift.” This article examines whether this return pattern persisted beyond the original sample end date and whether it is observed in additional asset classes. The equity return during the pre-FOMC window declined from 0.5% on average per FOMC meeting to roughly 0.1% in the out-of-sample period after 2011 and was no longer significant. Furthermore, the authors find no evidence of a pre-FOMC announcement effect in US nominal and real interest rates (US Treasuries and Treasury Inflation-Protected Securities), currencies ($/euro, $/British pound, $/Japanese yen, and $/Swiss franc), precious metals (gold and silver), and commodities (oil, heating oil, and natural gas). Results indicate that the pre-FOMC announcement drift was limited to equity markets and weakened significantly post-2011, consistent with market participants taking advantage of the anomaly or with a time-varying effect. However, the fact that the effect weakened postsample, but prepublication, rather than postpublication, may suggest this dynamic was sample specific. <b>TOPICS:</b>Security analysis and valuation, performance measurement, statistical methods

Pricing the Deflation Protection Option in TIPS Using an HJM Model with Inflation- and Interest-Rate Jumps

Much known about Treasury inflation-protected securities (TIPS) is related to the hedge they offer against inflation, but little is known about their protection against deflation—in the form of a deflation protection option (DPO). In this article, a pricing framework that builds on a Heath–Jarrow–Morton forward-rate economy with codependent inflation- and interest-rate jumps is derived to value this embedded DPO. The model prices for TIPS resulting from this pricing framework are found to most closely fit the 10-year notes issued following the 2008 crisis. Considering these notes accounted for over 70% of the total TIPS-market trading activity, this result underscores the importance of properly assessing DPO value in times of deflationary fears compounded by rising real yields, negligence of which may well be liable for the post-crisis mispricing in TIPS.

The Economic Value of TIPS Arbitrage Mispricing

Rational frictionless asset pricing models imply that inflation swap rates and break-even inflation rates with same maturity must be equal. The data, however, suggest a persistent positive difference between these two quantities, which the literature attributes to mispricing of Treasury Inflation-Protected Securities (TIPS). In theory, factors driving TIPS mispricing are not directly observable to the econometrician. To reveal these factors, we analyze the daily term structure of TIPS mispricing and uncover its information content. To assess its economic value, we derive novel high-frequency stylized facts about its dynamics. We document strong relationships with stock market returns, option-implied volatility and variance risk premium, and an important channel for predicting inflation, bond and equity excess returns, jointly.

Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices

Treasury Inflation-Protected Securities (TIPS) are frequently thought of as risk-free real bonds. Using no-arbitrage term structure models, we show that TIPS yields exceeded risk-free real yields by as much as 100 basis points when TIPS were first issued and up to 300 basis points during the 2007–2008 financial crisis. This spread predominantly reflects the poorer liquidity of TIPS relative to nominal Treasury securities. Other factors, including the indexation lag and the embedded deflation protection in TIPS, play a much smaller role. Ignoring this spread also significantly distorts the informational content of TIPS break-even inflation, a widely used proxy for expected inflation.