TIPS, Inflation Expectations, and the Financial Crisis

Abstract

The authors show that inefficiencies in the U.S. market for inflation-linked bonds can be exploited by informed traders who include survey estimates or inflation model forecasts in trades on breakeven inflation. The Treasury Inflation-Protected Securities market has yet to fulfill investors’ expectations as a low-risk, efficient, and liquid financial instrument.

Index-linked government bonds eliminate not only default risk but also inflation risk because they adjust cash flows for accrued inflation over time. In the past, the governments of many developed countries (e.g., the United Kingdom, Canada, and Sweden) issued inflation-linked bonds. In 1997, the U.S. Department of the Treasury followed suit by issuing Treasury Inflation-Protected Securities (TIPS).

We investigated the TIPS market to improve our understanding of the major factors that drive risk and returns in that asset class. Although earlier studies identified liquidity premiums as one possible if not major factor driving TIPS returns, the financial crisis of 2008 allowed us to examine how risk premiums related to index-linked government bonds are affected by changes in the perception and pricing of risk. Previous research indicated that the TIPS market is inefficient and that market inefficiencies can be exploited by informed traders who include survey estimations or inflation model forecasts in trades on breakeven inflation.

Our results—over a period in which the TIPS market matured and increased in depth while the volatility of real yields and inflation also increased—confirm that TIPS market inefficiency was not temporary but persisted from 1997 to 2009. Using estimations generated by the Survey of Professional Forecasters or forecasts based on an inflation-forecasting model to construct a breakeven trading strategy leads to excess returns over a static buy-and-hold strategy. These excess returns remain substantial even after accounting for trading costs.

A more detailed analysis of trading strategy–related excess returns suggests that the breakeven strategy performs well during periods of high macroeconomic volatility. This finding can be explained by an enhanced attractiveness of TIPS as uncertainty around future inflation increases. Thus, in general, TIPS market participants’ predictions of future inflation rates during periods of macroeconomic uncertainty are rather poor. Using a systematic approach to forecast inflation is, therefore, especially useful during times of economic uncertainty. Furthermore, our results suggest that the TIPS market has yet to fulfill investors’ expectations of being a low-risk, efficient, and liquid financial instrument. In particular, TIPS returns include a substantial liquidity premium, which, in addition to exposure to changes in real yields, may increase, rather than eliminate, risks in investors’ portfolios.

With respect to the financial crisis between the last quarter of 2008 and the second quarter of 2009, our observations further point to inefficiencies in the TIPS market. The most striking evidence from our results is that breakeven inflation turns negative. This finding implies that TIPS are not considered equivalent to government bonds, which leads to the requirement of a substantial liquidity premium for holding TIPS. Moreover, the liquidity premium appears to change significantly over time and to vary with such factors as perceived financial market stability.

Note: The views and opinions expressed in this article are the authors’ own and do not necessarily reflect the views and opinions of BlackRock.