An Empirical Decomposition of Risk and Liquidity in Nominal and Inflation-Indexed Government Bonds

Abstract

This paper decomposes inflation-indexed and nominal government bond excess return predictability into liquidity, real interest rate risk and inflation risk. We estimate a systematic liquidity premium in Treasury Inflation Protected Securities (TIPS) yields relative to nominal yields. The liquidity premium is around 30 bps during normal times but larger during the early years of TIPS and during the financial crisis 2008-2009. We find that time-varying liquidity premia in TIPS and time-varying inflation risk premia in nominal bonds generate return predictability. We find no evidence that shocks to relative issuance generate bond return predictability in the US or UK. Since their first issuance in 1997, inflation-indexed bonds in the U.S. have gained wide acceptance among investors and they now constitute a significant fraction of the stock of U.S. Treasury debt. Yet many academics and Treasury market pundits argue that these bonds, known as Treasury Inflation Protected Securities (TIPS), have a smaller and less liquid market than their nominal counterparts, U.S. Treasury notes and bonds.2 This paper conducts an empirical investigation of the sources and magnitude of illiquidity in the TIPS market. Conditional on a measure of the liquidity discount on TIPS relative to nominal Treasury bonds, it asks to what extent liquidity risk and to what extent time-varying inflation risk and time-varying real interest rate risk generate excess return predictability in government bonds. Understanding the liquidity differential between TIPS and Treasury bonds is important for several reasons. First, it is well-known that the Expectations Hypothesis of the term structure of interest rates does not hold for U.S. nominal government bonds (Campbell and Shiller 1991, Fama and Bliss 1987, Cochrane and Piazzesi 2005). Equivalently, excess returns on U.S. nominal government bonds are predictable. Explanations of return predictability in government bond returns emphasize either a time-varying real interest rate risk premium, or a time-varying inflation risk premium, or a combination of those two (Wachter 2006, Campbell, Sunderam, and Viceira 2010). Pflueger and Viceira (2011) have highlighted that inflation-indexed bonds can be very helpful in disentangling inflation risk and real interest rate risk as the fundamental sources of government bond return predictability. But such an exercise requires identifying price and return differentials between the two bond markets 2For evidence of relatively lower liquidity in TIPS see D’Amico, Kim, and Wei (2008), Campbell, Shiller, and Viceira (2009), Fleckenstein, Longstaff, and Lustig (2010), Fleming and Krishnan (2009), Dudley, Roush, and Steinberg Ezer (2009), Gurkaynak, Sack, and Wright (2010), and Haubrich, Pennacchi, and Ritchken (2011).

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