Efficient Investment Portfolios in a Real-Value Environment: Implications for Portfolio Managers and Bond Yields (2001)

ABSTRACT In early 1997 the U.S. Treasury began issuing inflation-indexed securities. This paper compares efficient portfolios containing an inflation-indexed security to portfolios without such a security. Inflation risk premiums that are required for traditional, nominal, non-indexed debt assets to replace an inflation-indexed security in efficient portfolios are estimated. Results are calculated and compared for the periods 1926-1995,1950-1995 and 1965-1995. JEL: G11, G12, D81 Keywords: Real return; Inflation-adjusted; Portfolio management; TIPS (for Treasury Inflation-Protected Securities); Indexation I. INTRODUCTION Until early 1997, when the U.S. Treasury issued inflation-indexed bonds, U.S. investment managers had no asset that provided an assured inflation-indexed return (1). Availability of inflation-indexed securities-constant-dollar-value assets--now offers new opportunities for optimizing portfolio risk-return tradeoff. This also poses new challenges, because some things considered to be true turn out to be false, or at least questionable, in the presence of inflation-indexed securities, when everything is benchmarked in real terms. In real, constant dollar terms over a multi-period investment horizon, a nominal dollar U.S. Treasury bill, the traditional risk-free asset, turns out to be anything but risk free. This is due to the uncertain future rate of inflation and the turnover of investment at future interest rates that cannot be known in advance. For the purposes of this study we assume that a security exists that offers a guaranteed fixed return after the effects of inflation. At present, those indexed securities that exist closely approximate, but do not exactly satisfy this ideal, because of lags in making the inflation adjustment (2) and the tax treatment accorded the adjustment. (3) Fluctuations in the market's real rate of return will affect the realized real rate of return, but a buy and hold strategy will minimize variations in the real rate of return. To approximate the actual (and worst case) results that may be expected with the new U.S. Treasury TIPS (Treasury Inflation Protected Securities), we examine the effects of lagging the inflation indexed return by 1, 2, and 3 months. II. A BRIEF HISTORY OF INFLATION-INDEXED SECURITIES The U.S. Treasury is a latecomer to offering inflation-adjusted securities. In modern times Finland in 1945 was the first nation to offer inflation adjustment in government financial instruments. Since then, many other nations have issued such debt. Table 1 shows the dates of implementation of inflation indexation in countries whose national governments offer such securities. In January, 1997 the United States issued its first inflation indexed bonds in two centuries. (4) The initial securities offered were 10-year inflation-indexed notes. This was followed by a 5-year inflation-indexed note and a 30-year bond. These securities are issued with a single price in a Dutch auction, as are the current non-indexed 2- and 5-year notes. Bidding is on the basis of real yield, expressed to three decimal places. The index used to measure inflation is the CPI-U, the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers, which is published monthly by the Bureau of Labor Statistics of the U.S. Department of Labor. (5) The market yield on these securities, over the inflation rate, has remained around 3-5/8 percent. Issue of inflation-indexed securities by the federal government will likely pave the way for acceptance of privately issued inflation adjusted securities. (6) Also, the current tax treatment of the phantom income from inflation adjustment may serve to focus public attention on how current U.S. tax law penalizes preservation of purchasing power, and thus may eventually help lead to revision of the tax code. In the U.K. there is no tax on the inflation-induced increase in the nominal principal. …