The TIPS‐Treasury Bond Puzzle

Fleckenstein, Matthias; Longstaff, Francis A.; Lustig, Hanno

doi:10.1111/jofi.12032

Cited by 226 publications

(173 citation statements)

References 121 publications

(177 reference statements)

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“…This synthetic 'nominal' bond is essentially a combination of a series of inflation swap contracts and a TIPS issue, whose cash flows are converted into fix payments, exactly matching those of the corresponding nominal bond. Fleckenstein et al (2014) find that the replicating portfolio is persistently underpriced, and they attribute this to the underpricing of TIPS. To offer an alternative explanation, we replicate their strategy and incorporate our estimated liquidity effects.…”

Section: Non-technical Summarymentioning

confidence: 99%

“…by Fleckenstein et al (2014), is an artifact of liquidity premiums. We view our work as an extension of Fleckenstein et al (2014) and Fleckenstein (2013), as we investigate the same no-arbitrage relationship between nominal and indexed Treasuries.…”

Section: Related Literaturementioning

confidence: 99%

“…Moreover, TIPS have a large natural clientele: pension funds and insurers prefer to include these bonds in their asset portfolios to better hedge inflation risk of their long maturity liabilities, while investment banks and hedge funds often use TIPS in breakeven trades or hedging portfolios. Fleckenstein et al (2014) document the TIPS-Treasury puzzle: 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 they attribute to the underpricing of TIPS.…”

Section: Non-technical Summarymentioning

confidence: 99%

“…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.…”

mentioning

confidence: 99%

“…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.…”

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confidence: 99%

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

2014

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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...

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Section: Non-technical Summarymentioning

confidence: 99%

Section: Related Literaturementioning

confidence: 99%

Section: Non-technical Summarymentioning

confidence: 99%

mentioning

confidence: 99%

mentioning

confidence: 99%

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

2014

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Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Pflueger

Viceira²

2016

Handbook of Fixed‐Income Securities

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There is wide consensus among financial economists that returns on nominal U.S. Treasury bonds in excess of Treasury bills are predictable at different investment horizons. Predictor variables include forward rates (Fama and Bliss, 1987), the slope of the yield curve (Campbell and Shiller, 1991), and a linear combination of forward rates (Cochrane and Piazzesi, 2005). There is however an ongoing discussion about what drives this predictability. We contribute to this discussion by conducting a joint empirical analysis of the sources of excess bond return predictability in nominal and inflation-indexed bonds in the U.S. and the U.K. Specifically, we provide evidence that both time-varying inflation risk premia and time-varying real interest rate risk premia are quantitatively important in explaining time variation in the expected excess return on nominal bonds. The question whether expected excess returns of inflation-indexed bonds are time-varying is important on its own. It remains relatively unexplored, partly due to the short history of U.S. inflation-indexed bonds (Campbell, Shiller, and Viceira, 2009). We contribute to the emerging research on inflation-indexed bonds by examining and distinguishing among three potential sources of excess return predictability in inflation-indexed bonds: time-varying real interest rate risk, timevarying liquidity risk, and market segmentation. Our work differs from recent work on inflationindexed bond return predictability by Campbell, Sunderam, and Viceira (2013) and Pflueger and Viceira (2011) in that it finds and corrects for an economically significant liquidity risk premium, which otherwise would likely distort estimates of real rate and inflation risk premia. Novel and unique to our work is the finding that a liquidity component in breakeven inflation, or the spread between nominal and inflation-indexed bond yields of similar maturity, predicts the return differential between nominal and inflation-indexed bonds due to liquidity. The estimated U.S. return differential due to liquidity exhibits a significantly positive stock market CAPM beta, suggesting that U.S. TIPS investors bear systematic liquidity risk and should be compensated in terms of a positive return premium. While the return differential due to liquidity is not directly 1 tradable, this result is relevant to investors who may differ in terms of their exposure to liquidity crises. Research in financial economics has proposed several theories to explain predictability in nominal excess bond returns. One hypothesis is that excess return predictability results from time variation in the aggregate price of risk. Building on the habit preferences model of Campbell and Cochrane (1999), Wachter (2006) shows that a model with time-varying real interest rates can generate nominal bond excess return predictability. Second, excess return predictability could result from time variation in expected aggregate consumption growth or its volatility. The long-run consumption risk model of Bansal and Yaron (2004) and Bansal, Kik...

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