Encyclopedia of Financial Models, 3 Volume Set

Quantitative Approaches to Inflation-Indexed Bonds

WESLEY PHOA, PhD

Senior Vice President, Capital International Research, Inc.

Abstract: Inflation-indexed bonds, as a way of financing government debt, were proposed in the 1920s by economists such as Alfred Marshall and John Maynard Keynes. In Israel, they have been issued since the 1950s and have often dominated that country’s bond market. Inflation-indexed sovereign bonds now exist in a broad range of developed countries, as well as in a number of emerging markets. A wide variety of bond structures and tax regimes exist. Issuance volumes and the breadth of the investor base vary widely from country to country; liquidity varies from reasonably good to very poor. When inflation-indexed bonds were introduced in the United States in 1997, there was some disagreement about the degree to which inflation-indexed bonds—called Treasury inflation-protected securities or TIPS—are “risk-free” and the role they should play in a portfolio. In particular, it had not been universally appreciated that these bonds can have volatile mark-to-market returns.

Since their introduction in 1997, Treasury inflation-protected securities (TIPS) have become an established part of the U.S. bond market. This entry reviews the structure of TIPS and the factors that drive TIPS returns; examines the role that TIPS play in a broader bond portfolio, and the nature of TIPS interest rate risk; and discusses some methods employed by TIPS investors to assess value ...