Empirical TIPS

Abstract

U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS) were first issued in January 1997. Through the third quarter of 2003, 12 TIPS had been issued, with original maturities ranging from 5 to 30 years. One TIP bond has already matured. This study documents the correlations of TIPS returns with the returns on nominal bonds and with equity returns over the past seven years; TIPS real and effective nominal durations; and changes in the volatility of TIPS over time. TIPS are used here to estimate real yield curves, which are then compared against nominal yield curves to derive the term structure of anticipated inflation on a daily basis. An explanation offered for the dramatic decline in TIPS real yields since 1999 is supported by empirical tests. Finally, given plausible assumptions about future expected returns, the article shows that an investment portfolio diversified between U.S. equities and nominal bonds would be improved by the addition of TIPS. U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS) were first issued in January 1997. Through the third quarter of 2003, 12 TIPS have been issued, with original maturities ranging from 5 years to 30 years. One TIP bond has already matured. With the accumulation of almost seven years of daily TIPS trading experience, sample sizes are more than adequate to establish some empirical facts about TIPS behavior. So, now seems to be a good moment to undertake a systematic empirical study of these interesting new assets. This study reports correlations of TIPS returns with the returns on nominal bonds and with equity returns over the past seven years. It calculates TIPS real and effective nominal durations and traces changes in the volatility of TIPS returns over time. It presents empirical measures of the effective nominal durations of TIPS and their return sensitivities to changes in the shape of the nominal term structure of interest rates. The study finds that TIPS return volatility has varied remarkably over their available history. TIPS provide an opportunity to estimate the entire term structure of anticipated inflation by comparing real yields on TIPS and ordinary yields on nominal bonds.TIPS real yields have declined dramatically since 1999. The article offers a tax-based explanation (with some supporting evidence). Finally, the article assesses the benefits of including TIPS in a balanced and diversified investment portfolio.

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