The Missing Piece of the Puzzle: Liquidity Premiums in Inflation-Indexed Markets

Abstract

Inflation-indexed products constitute a multitrillion dollar market segment worldwide. These assets can be found in many investment and hedging portfolios: the most common inflation payers are sovereigns, utility companies, and real estate investors; while on the receiver side pension and insurance funds, asset managers and investment banks are the most prominent counterparties. Despite their practical importance and the corresponding anecdotal evidence, studying liquidity characteristics of these assets has not attracted academic attention comparable to that of nominal bonds. Nevertheless, understanding these liquidity effects is important for several reasons. First, liquidity effects directly matter for the relative pricing of nominal and indexed bonds, as well as for the breakeven inflation rate implied by these prices. Similarly, liquidity effects in inflation swaps distort the inflation expectations that can be extracted from quoted swap prices.We show that in both index-linked bond markets and inflation swap markets liquidity is an important determinant of prices. We do so by estimating a model with both a liquidity risk factor and asset-specific liquidity characteristics. To estimate the effect of liquidity risk, we measure an asset's exposure to a non-traded liquidity factor. In addition to this risk exposure, the level of liquidity is proxied by asset-level characteristics. We conduct our analyses based on two alternative assumptions -we either propose the three markets being segmented (benchmark case), such that prices are independently determined, or integrated markets. We find strong evidence that the level of liquidity affects yields of TIPS, whereas inflation swap yields include a liquidity risk premium. More specifically, for TIPS, the effect of illiquidity risk is dominated by that of asset characteristics. Age and size of an issue together carry a sizable premium of about 33 basis points per year. As for inflation swaps, we find that illiquidity risk is priced, yet the premium and the implied economic effect, 1.65 basis points per year, are small. We also study liquidity effects in nominal bonds in a similar way, and find a small liquidity risk premium in the nominal bond market, similar in magnitude to that of the on-the-run spread. In integrated markets, results regarding TIPS and nominal Treasuries are akin to the benchmark case, however, the price of illiquidity risk in the swap market is negative and twice as large as in the benchmark case, -3.41 basis points per year.Additionally, we also study whether the exposure to liquidity and liquidity risk could explain the persistent difference in relative bond prices, as documented by Fleckenstein et al. (2014). They uncover a material price difference between nominal bonds and inflation-swapped indexed bonds (TIPS) that exactly replicate the cash flows of the nominal bond. This replicating portfolio trades at a discount relative to nominal bonds, which is mostly attributed to the underpricing of TIPS. But what could be the reason for this underpr...