An Empirical Decomposition of Risk and Liquidity in Nominal and Inflation-Indexed Government Bonds
Executive Summary — The yields on US Treasury Inflation Protected Securities (TIPS) have declined dramatically since they were first issued in 1997. This paper asks to what extent the returns on nominal and inflation-indexed bonds in both the US and the UK can be attributed to differential liquidity and market segmentation or to real interest rate risk and inflation risk. Key concepts include:
- Over the 10 year period starting in 1999 the average annualized excess log return on 10 year TIPS equaled a substantial 4.16 percent, almost a full percentage point higher than that on comparable nominal US government bonds.
- These differential returns are notable, because both nominal and inflation-indexed bonds are fully backed by the US government. Moreover, the real cash flows on nominal bonds are exposed to surprise inflation while TIPS couponsand principal are inflation-indexed.
- The authors find strong empirical evidence for two different potential sources of excess return predictability in inflation-indexed bonds: real interest rate risk and liquidity risk. Empirical evidence is also provided showing that nominal bond return predictability is related not only to time variation in the real interest rate risk premium, but also to time variation in the inflation risk premium.
This paper decomposes the excess return predictability in inflation-indexed and nominal government bonds into effects from liquidity, market segmentation, real interest rate risk, and inflation risk. We estimate a large and variable liquidity premium in US Treasury Inflation Protected Securities (TIPS) from the co-movement of breakeven inflation with liquidity proxies. The liquidity premium is around 70 basis points in normal times, but much larger during the early years of TIPS issuance and during the height of the financial crisis in 2008-2009. The liquidity premium explains the high excess returns on TIPS as compared to nominal Treasuries over the period 1999-2009. Liquidity-adjusted breakeven inflation appears stable, suggesting stable inflation expectations over our sample period. We find predictability in both inflation-indexed bond excess returns and in the spread between nominal and inflation-indexed bond excess returns even after adjusting for liquidity, providing evidence for both time-varying real interest rate risk premia and time-varying inflation risk premia. Liquidity appears uncorrelated with real interest rate and inflation risk premia. We test whether bond return predictability is due to segmentation between nominal and inflation-indexed bond markets but find no evidence in either the US or in the UK.