Academic journal article International Advances in Economic Research

Information Content of U.S. Treasury Inflation-Indexed Bonds

Academic journal article International Advances in Economic Research

Information Content of U.S. Treasury Inflation-Indexed Bonds

Article excerpt

MALEK LASHGARI [*]

U.S. Treasury inflation-indexed bonds are designed to provide a stable real return before taxes. A comparison between these bonds and conventional bonds reveals that the effective real yield of U.S. Treasury inflation-indexed bonds is attractive. The econometric results suggest, however, that the real rate provided by U.S. Treasury inflation-indexed bonds is not independent of inflation, implying that the Fisher hypothesis is contradicted by the data. An implication of negative correlation between the real rate and inflation is that the time to buy U.S. Treasury inflation-indexed bonds is when inflation is low. While the yields on U.S. Treasury inflation-indexed bonds are shown to reflect inflation by a lag of about one month, nominal interest rates do not fully adjust to inflation. (JEL GOO, GJ, GJO)

Introduction

The latest innovation in the U.S. Treasury securities market is the U.S. Treasury inflation-indexed bond, which provides protection against inflation by offering a constant real return for the life of the bond. The initial real coupon rate of 3.375 percent, corresponding with a yield of 3.449 percent, was attractive for the 10-year U.S. Treasury inflation-indexed bonds issued on January 29, 1997.

Similar to conventional bonds, the stated coupon rate for U.S. Treasury inflation-indexed bonds stays the same during its life. However, since the principal value of the bond will adjust for changes in inflation over time, investors will be protected against inflation by receiving a higher but variable nominal income. The final principal value of these bonds will also include full compensation for inflation. During deflationary times, both the interest income and the year-by-year principal value of U.S. Treasury inflation-indexed bonds would decline. However, the U.S. government guarantees a minimum of $1,000 in principal payment at maturity.

U.S. Treasury inflation-indexed bonds thus provide a stable real rate of return, together with protection against unanticipated changes in inflation. Evidence from the Israeli inflation-indexed bonds from 1970 to 1979 reveals that inflation-indexed bonds had produced a stable real return while reflecting about 85 percent of the unanticipated inflation [Huberman and Schewert, 1985]. Similarly, as Woodward [19921 analyzed monthly returns on the inflation-indexed bonds in the United Kingdom during April 1982 to August 1990, he found a relatively constant real after-tax rate of return.

U.S. Treasury inflation-indexed bonds would appear to provide a useful tool for the Federal Reserve policy makers in their inflation-fighting endeavors. Bach and Musgrave [1941] note that in boom periods, investors may be attracted to these bonds as a hedge against inflation instead of hoarding commodities or gold. This, in turn, would tend to take some pressure off commodities prices.

Meanwhile, the U.S. Treasury Department may be able to lower its cost of financing by not paying an excessive inflation premium. The inflation premium embedded in nominal bonds (that is, the reward expected by investors associated with unanticipated changes in inflation) may be higher than justified by the actual inflation over the life of the nominal bond. Brynjolfsson and Faillace [1997] estimate the excess premium to be between 0.5 percent to 1.0 percent.

Historical data provide ample evidence of the poor performance of regular bonds during periods of rising and unanticipated inflation. In such an environment, defined-benefit pension plans, for example, whose liabilities are tied to inflation, would benefit from investing in U.S. Treasury inflation-indexed bonds.

This paper finds that while the real return on U.S. Treasury inflation-indexed bonds is statistically equal to the average real return on the nominal government bonds for 1982 to 1997, it is superior to those of prior time intervals. This finding is in support of Siegel [1998] who shows that the inclusion of U. …

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