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1 INFLATION INDEXED SECURITIES: A USER’S PERSPECTIVE Presented at Boston QWAFAFEW, March 1998 Ron D’Vari, Ph.D.,CFA.

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Presentation on theme: "1 INFLATION INDEXED SECURITIES: A USER’S PERSPECTIVE Presented at Boston QWAFAFEW, March 1998 Ron D’Vari, Ph.D.,CFA."— Presentation transcript:

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2 1 INFLATION INDEXED SECURITIES: A USER’S PERSPECTIVE Presented at Boston QWAFAFEW, March 1998 Ron D’Vari, Ph.D.,CFA

3 TIPS, Ron D'Vari 2 ANATOMY OF NOMINAL INTEREST RATES FACTORS INFLENCING INFLATION EXPECTATIONS REVIEW OF TIPS AND CIPS (STRUCTURE, HISTORY,ETC.) PROS AND CONS OF TIPS REAL VS NOMINAL RISK MEASURES TIPS VALUATION AND BREAKEVEN ANALYSIS US CPI-URN-NSA HISTORICAL PERFORMANCE TACTICAL VS STRATEGIC USE OF TIPS/CIPS AGENDA

4 TIPS, Ron D'Vari 3 ANATOMY OF NOMINAL INTEREST RATES EXPECTED REAL RATE EXPECTED INFLATION RISK PREMIA UNEXPECTED REAL RATE PREMIUM UNEXPECTED INFLATION PREMIUM OTHER RISKS’ PREMIA LIQUIDITY CREDIT ETC LESS CONVEXITY BIAS

5 TIPS, Ron D'Vari 4 ANATOMY OF NOMINAL INTEREST RATES REAL RATE = EXPECTED REAL + UNEXP. REAL PREMIUM - REAL CONVEXITY BIAS + LIQUIDITY PREMIUM BEIIR = EXPECTED INFLATION + UNEXP. INFLATION + (REAL-NOMINAL) CONVEXITY BIAS - REAL LIQ. PREM.

6 TIPS, Ron D'Vari 5 FACTORS INFLUENCING INFALTION EXPECTATIONS ECONOMIC GROWTH TRADE POLICIES/ BARRIERS MONETARY & FISCAL POLICIES LABOR MARKETS GOODS MARKETS DOMESTIC INTERNATIONAL GLOBAL COMPETITION CURRENCY REGIMES/POLICIES PRODUCTIVITY GROWTH CAPITAL GOODS INVESTMENT

7 TIPS, Ron D'Vari 6 HIGHER CONFIDENCE ON US MONETARY AND FISCAL POLICIES  Global emulation of US economic policies STRONG US DOLLAR (LOW IMPORTED INFLATION)  Southeast Asia new free currency regime  Yen’s further weakening PRODUCTIVITY IMPROVEMENTS  Computer technology payoffs  Investments in capital equipment GLOBAL EXCESS CAPACITY LOWER TRADE BARRIERS  Increased global competition  Low pricing power RISKS: Low unemployment, increased union power, inflated financial asset prices CURRENT DRIVERS OF LOW INFLATION

8 TIPS, Ron D'Vari 7 POSSIBLE INFLATION-LINKED STRUCTURES –Interest Indexed (less inflation protection) –Capital Indexed (more inflation protection) –Zero-coupon Indexed (most inflation protection) –Indexed Annuity MOST DESIRABLE : Capital Indexed –3.375% Real Coupon, Actual/Actual, Semia Annual (SA) –Nominal SA Coupon Payaouts Original Par Amount * (Index Ratio on Coupon Date) * ( 3.375%)/2 –Current Principal = Indexed to CPI (accretes with CPI-U) At maturity it is Max (100 * CPI-U Index/Ref Index, 100) VARIOUS STRUCTURES

9 TIPS, Ron D'Vari 8 Nominal Price is a function of past inflation not future inflation (3-Month Lagged CPI-U Index on Settlement Date) Index Ratio = ( 3-Month Lagged CPI-U Index on Issuance Date) Price/Yield calculation is done in real domain and converted to nominal by the index ratio

10 TIPS, Ron D'Vari 9 Revisions to CPI Calculation Methodology - Uncertain Can be lower as much as 0.5%/Year More an issue with 10- and 30-years than 5-year Stripping Has Been Clarified  Coupon and principal strips of different bonds are combinable  Different bonds different reference index ratios  For tax purposes, strips will be treated as OID  No stripping has yet occurred Trading Practices - Straightforward  PSA a "Trading Practice Guidelines  Price and quotation on real basis  Settlement price is adjusted based on settlement index ratio  Forward pricing beyond a month is problematic OTHER ISSUES

11 TIPS, Ron D'Vari 10 Forward Pricing Analysis Cost of Carry Analysis Buy/Sell Back Repo Analysis Inflation Indexed Bond Futures CPI-U Swap Analysis CPI-U Linked Options DERIVATIVES PRICING

12 TIPS, Ron D'Vari 11 TIPS’ BASIC STRUCTURE  Principal adjusted daily based on 3-m lagged index ratio  Index = NSA CPI-U (all items for all urban consumers) Nov. 96 ==> Feb 1, 97 and Dec. 96 ==> March 1, 97 Linearly interpolated in between  Principal adjustments are not paid out periodically (treated like a zero - compounds daily)  Semi-annual coupon (real) based on adjusted principal  100% of Original Principal is Guaranteed at Maturity Prin. At Maturity = Max [Orig. Prin., Orig. Prin. x Index Ratio at Mat.]  CAN BE STRIPPED DRAWBACKS OF US TIPS STRUCTURE  Principal Appreciation Taxed Annually  Can lead to negative nominal cash flows (high inflation)  Less attractive for taxable entities such as retail investors US TIPS: A BRIEF HISTORY

13 TIPS, Ron D'Vari 12 ISSUANCE  QUARTERLY SINGLE-PRICE AUCTIONS 5YR: 7/97 for $8.4Bil, 10/97 for $8.0Bil (Mat 7/02) 10YR: 1/97 for $7.6Bil, 04/97 for $8.4Bil (Mat 1/07) 1/98 for $8.0Bil, 10/98 for $8.0Bil (Mat 1/08) 1/99 for $7.0Bil, (Mat 1/07) 30YR: 4/98 for $8.0Bil, 07/98 for $8.0Bil (Mat 4/28) 4/99 for $6.0Bil (Mat 4/29)  INITIAL AUCTION WAS VERY SUCCESSFUL (Bid/Cover of 5.2 at Real Yield of 3.44%)  LACKLUSTER RETAP OF 10-YR AND 5-YR AUCTIONS  US TREASURY HAS EXPRESSED ITS COMMITMENT TO THE TIPS PROGRAM US TIPS: A BRIEF HISTORY

14 TIPS, Ron D'Vari 13 US TIPS: AUCTION HISTORY LIQUIDITY  HAS BEEN INLINE WITH EXPECTATION SO FAR  EXPECTED TO INCREASE WITH ISSUANCE  IN FUTURE YEARS CAN BE AS MUCH AS 30% OF NEW COUPON ISSUANCE  WILL SOON SURPASS ANY OTHER FOREIGN I/L MARKETS

15 TIPS, Ron D'Vari 14 CPI-URN SEASONAL EFFECT

16 TIPS, Ron D'Vari 15 CPI-URN-NSA TREND

17 TIPS, Ron D'Vari 16 SHORT REAL RATE TREND

18 TIPS, Ron D'Vari YR=4.95%, 10-YR=3.54%, 5-YR=2.68%, 3-YR=2.57% 1-YR=2.23% CPI-U NSA PAST PERFORMANCE

19 TIPS, Ron D'Vari 18 SOME CORPORATE ISSUANCE  TVA, $300MM, 10-YR  FHLB, $200MM, 10YR  JP Morgan, $200MM, 15YR  Salomon Brother, $400MM, 5YR  Toyota Motor Credit, $100MM, 5YR HAS SLOWED SIGNIFICANTLY RELATED ISSUES Advantages and Disadvantages From Issuer Perspective - Diverse motivation for Issuance Alternative to Short Term or Long Term Debt? Hedged vs. Unhedged Issuance VALUATION ISSUES Total Inflation Protection vs. Non -Accretion Relative Value Analysis for Different Structures MIPS (Munis) PROTECTED FROM INFLATION AND TAXES Before-tax yields are very low (CPI+1%) Only riskless asset? CORPORATE, AGENCY, AND MUNIES ISSUANCE

20 TIPS, Ron D'Vari 19 REAL VS NOMINAL RISK MEASURES

21 TIPS, Ron D'Vari 20 NOMINAL HEDGES CAN BE IMPERFECT

22 TIPS, Ron D'Vari 21 5YR TIP’S RISK

23 TIPS, Ron D'Vari YR TIP’S RISK

24 TIPS, Ron D'Vari 23 30YR TIP’S RISK

25 TIPS, Ron D'Vari 24 5YR Vs 10YR TIPS’ Historical Yield Spreads

26 TIPS, Ron D'Vari 25 5YR Vs 10YR TIPS’ Yield History

27 TIPS, Ron D'Vari 26 5Yr Vs 10Yr TIPS’ Price Regression

28 TIPS, Ron D'Vari 27 5Yr Vs 10Yr TIPS’ Yield Regression

29 TIPS, Ron D'Vari 28 5-YR TIPS VALUATION

30 TIPS, Ron D'Vari 29 5-YR TIPS VALUATION

31 TIPS, Ron D'Vari YR TIPS VALUATION

32 TIPS, Ron D'Vari YR TIPS DURATION BASED ON SCENARIO ANALYSIS

33 TIPS, Ron D'Vari 32 STRATEGIC  DIVERSIFICATION REDUCED RISK HIGHER SHARP RATIO  REDUCE RELATIVE RISK (NOT VALID ANYMORE) TIPS WERE INCLUDED IN LEHMAN AGGREGATE INDEX UNTIL 12/31/97  LIABILITIES INDEXED TO INFLATION TACTICAL  ENHANCE RELATIVE PERFORMANCE DUE TO - UNANTICIPATED REAL GROWTH SLOW DOWN - UNANTICIPATED INFLATION PICK UP (LESS SO)  BUY INTEREST RATE PROTECTION CHEAP PORTFOLIO USE

34 TIPS, Ron D'Vari 33 Piet M.A. Eichholtz, ET. AL, Journal of Fixed Income, December of 1993  UK: January 1983 to December 1992  Israel: January 1984 through May 1992  Used Cash, Nominal and IL Bonds/Bills and Equity  Considered both low and high levels of risk tolerance


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