Understanding Inflation-Indexed Bond Markets

ABSTRACT This paper explores the history of inflation-indexed bond markets in the United States and the United Kingdom. It documents a massive decline in long-term real interest rates from the 1990s until 2008, followed by a sudden spike during the financial crisis of 2008. Breakeven inflation rates, calculated from inflation-indexed and nominal government bond yields, were stable from 2003 until the fall of 2008, when they showed dramatic declines. The paper asks to what extent short-term real interest rates, bond risks, and liquidity explain the trends before 2008 and the unusual developments that followed. Low yields and high short-term volatility of returns do not invalidate the basic case for inflation-indexed bonds, which is that they provide a safe asset for long-term investors. Governments should expect inflation-indexed bonds to be a relatively cheap form of debt financing in the future, even though they have offered high returns over the past decade. ********** In recent years government-issued inflation-indexed bonds have become available in a number of countries and have provided a fundamentally new instrument for use in retirement saving. Because expected inflation varies over time, conventional, nonindexed (nominal) Treasury bonds are not safe in real terms; and because short-term real interest rates vary over time, Treasury bills are not safe assets for long-term investors. Inflation-indexed bonds fill this gap by offering a truly riskless long-term investment (Campbell and Shiller 1997; Campbell and Viceira 2001, 2002; Brennan and Xia 2002; Campbell, Chan, and Viceira 2003; Wachter 2003). The U.K. government first issued inflation-indexed bonds in the early 1980s, and the U.S. government followed suit by introducing Treasury inflation-protected securities (TIPS) in 1997. Inflation-indexed government bonds are also available in many other countries, including Canada, France, and Japan. These bonds are now widely accepted financial instruments. However, their history creates some new puzzles that deserve investigation. First, given that the real interest rate is determined in the long run by the marginal product of capital, one might expect inflation-indexed bond yields to be extremely stable over time. But whereas 10-year annual yields on U.K. inflation-indexed bonds averaged about 3.5 percent during the 1990s (Barr and Campbell 1997), and those on U.S. TIPS exceeded 4 percent around the turn of the millennium, by the mid-2000s yields on both countries' bonds averaged below 2 percent, bottoming out at around 1 percent in early 2008 before spiking to near 3 percent in late 2008. The massive decline in long-term real interest rates from the 1990s to the 2000s is one puzzle, and the instability in 2008 is another. Second, in recent years inflation-indexed bond prices have tended to move opposite to stock prices, so that these bonds have a negative "beta" with the stock market and can be used to hedge equity risk. This has been even more true of prices on nominal government bonds, although these bonds behaved very differently in the 1970s and 1980s (Campbell, Sunderam, and Viceira 2009). The reason for the negative beta on inflation-indexed bonds is not well understood. Third, given integrated world capital markets, one might expect that inflation-indexed bond yields would be similar around the world. But this is not always the case. During the first half of 2000, the yield gap between U.S. and U.K. inflation-indexed bonds was over 2 percentage points, although yields have since converged. In January 2008, 10-year yields were similar in the United States and the United Kingdom, but elsewhere yields ranged from 1.1 percent in Japan to almost 2.0 percent in France (according to Bloomberg data). Yield differentials were even larger at long maturities, with U.K. yields well below 1 percent and French yields well above 2 percent. To understand these phenomena, it is useful to distinguish three major influences on inflation-indexed bond yields: current and expected future short-term real interest rates; differences in expected returns on long-term and short-term inflation-indexed bonds caused by risk premiums (which can be negative if these bonds are valuable hedges); and differences in expected returns on long-term and short-term bonds caused by liquidity premiums or technical factors that segment the bond markets. …