Saturday, October 18, 2008

What is going on with the inflation indexed treasuries?

Strange things are happening in markets, but one development that I have seen little comment on is what is happening in the US treasury market. The Treasury has been issuing traditional bonds (where the coupon is set at the time of the issue) and inflation-indexed bonds (where a real return of return is guaranteed at the time of the issue) for more than a decade now. On September 12, 2008, the nominal 10-year treasury bond rate was about 3.8% and the interest rate on the inflation-indexed treasury was about 1.7%. In fact, the difference can be viewed as a market expectation of inflation over the 10 years (about 2.1% a year). Those numbers had been stable for years before.
For the first 10 days of the crisis, the relationship held, with the 10-year nominal and real rates staying relatively unchanged. About 2 weeks ago, the ten-year real rate started rising even though the nominal rate remained unchanged. On Friday, the nominal 1o-year rate was 3.9% (about 0.1% higher than it was at the start of the crisis) but the real rate had rised to 3%. I have attempted the following explanations but none hold up:
1. The real interest rate has risen because savers are more worried about investing in any type of financial asset. (Counter: If this is the case, why has the nominal rate also not risen)
2. Expected inflation has decreased because the economy has slowed. (Counter: If this is the case, both the nominal and real rates should have come down. It is also hard for me to believe that all these obligations taken on by the Federal government will not translate into higher inflation, not lower.)
The only explanation that I can think off is that investors who traditionally hold the inflation-indexed treasuries are selling them for liquidity reasons. If that is the case, we should expect a bounce back in the real interest rate to more conventional levels (about 1.5-2%), which would make inflation-indexed treasuries a great investment. The next few weeks should tell.


Heshrulz said...


Is this not then a good bet for convergence trade - Short sell nominal return bonds and long inflation indexed bonds? i.e, for that small community who still have liquidity.

About the point of liquidity. Shouldn't lack of liquidity apply equally if not more to nominal return bond subscribers also?

Aswath Damodaran said...

Good point about liquidity but the populations that hold these bonds can be very different and consequently be affected by illiquidity.

Gaurav Mehta said...

Can this be a reason that inflation indexed treasuries are generally more illiquid than nominal return bonds?

Gaurav Mehta said...

Can this be a reason for the rise in rates of inflation indexed treasuries that generally inflation indexed treasuries are more illiquid in nature with lesser number of investors?

Pat L said...

If I'm not mistaken, most inflation indexed bonds are held in non-taxable accounts because the principal adjustment is taxable but doesn't produce cash flow. This probably makes them less liquid than taxable treasuries. It might only take a couple of large non-taxable institutions dumping these bonds to drive up the yields.

Aswath Damodaran said...

I think pat I is right though I am amazed at the move in an investment that is supposedly low risk. An illustration of why liquidity matters in a market like this one and why convergence trades may get you into trouble, unless you can afford to wait out the crisis.

gmrbluee said...

I will go with explanation #2. With the economy going into deep recession and falling commodity prices I think inflation expectations have come way down. Is it justified given the liabilities the US government has just taken on? Unlikely, but who knows.
As for the 10 year treasuries, that’s where I think you have the real bubble, with flight to safety keeping rates lower than they should be.
Finally, I would love to get 3%+ inflation. The problem is that I don’t trust the official CPI numbers to give me protection against the “real world inflation”.

Georg said...


There was a message that US govt poured some USD 3,5 trln to manage crisis so far and Paulson's 700 bln was not the first injection. Unfortunatly I can't manage to find the link now.

With simultaneous fed rate and eurobank interest rate reductions we might not notice dollar deflation effect?

1. Overall, aren't there many factors for dollar inflation to be much greater then nominal yields indicate?

2. Re: risk premium. Is there a possibility that S&P decline is caused by liquidity problems and investors willing to close their positions? I.e. that factor other then implied risk premium affects company's cap?

Gianni y Daniela said...

I believe to be two distinct scenarios: high inflation, or deflation; both very concerning, but as the market has yet to see the liquidity effect of decrease in interest rates, bailout, equity in banks the thesis holds best for deflation. In this case real interest rates should be above nominal, nonetheless there is still a small probability of higher inflation which when you adjust expectations accordingly give you a small spread or inflation expectation. In other words it is a combination of high probability (80%) of deflation (-1 or 1.5%) plus a low probability (20%) of high inflation (8-10%).

Henry said...

Professor Damodaran,

The Cleveland Fed's website actually discusses liquidity concerns re: TIPS and adjusts the expected inflation estimate as derived from TIPS for liquidity purposes:

Nonetheless, expected inflation as derived from TIPS has come down despite the Cleveland Fed's "liquidity adjustments."


hschonzeit said...

Professor Damodaran,

After reading all the comments, I'm still not sure why the TIPS are being priced the way they are now. But, it does seem that a real YTM of 3.5% or better on these ultrasafe investments is a good deal. There is one caveat though, the prospect of deflation. It does seem like the spread against treasuries appears to say the market is expecting deflation. As an investor, I'd buy recently issued TIPS, so that even if there is deflation you'd only be subject to losing the most recent inflation accrual, since the bonds can't go below par. In the unlikely event that we experience long-term deflation, these bonds would actually perform better, since they'd be generating interest on the original par value.

Any comments?

Also, I've been unsuccessful in finding on-line discussion blogs on TIPS and if anyone knows of any, I'd appreciate the link.

Create store cards said...

I do believe to get a couple distinct cases: excessive inflation, as well as deflation; the two quite related to, but since the market has but to see your liquidity influence of decrease in rates of interest, bailout, value in banking companies your thesis retains finest with regard to deflation. In cases like this actual rates of interest needs to be above nominal, even so there is certainly still a tiny probability of greater inflation that when you alter anticipation Create store cards consequently supply you with a small distribute as well as inflation expectation. Basically this is a combination of excessive probability (80%) of deflation (-1 as well as 1. 5%) including a small probability (20%) of excessive inflation (8-10%).

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