The Impact of Liquidity on Inflation-Linked Bonds: A Hypothetical Indexed Bonds Approach

Abstract

The sovereign's intention to issue inflation-linked bonds (ILB) is to save money. More than 15 years' experience with this financial instrument in the United States and in several other countries has led to the conclusion that these bonds are costly and basically characterized by low liquidity issues. Recently, various papers have started to analyze the impact of liquidity on ILB yields. This paper summarizes studies concerning ILB liquidity at a glance and adds a new estimation strategy of the liquidity premium based on Campbell & Shiller's (1996) hypothetical ILB yields. We calculate the difference between observed and hypothetical ILB yields, regress this time series on a set of ILB-specific liquidity as well as general market uncertainty measures and find statistically and economically significant effects of the liquidity measures for the United States, the United Kingdom and Canada.

Estimating Inflation Risk Premia Using Inflation‐linked Bonds: A Review

“…For regression‐based approaches or term structure models that use liquidity‐adjusted ILB yields as input data, these proxies are used in a regression to estimate the liquidity premium (see, e.g. Hördahl and Tristani, , or Auckenthaler et al ., ). Term structure models that explicitly incorporate liquidity uses these proxies in a principal component analysis to extract one (or more) liquidity factors (see Abrahams et al ., ).…”

“…The inflation risk premium's development over time, however, varies considerably across the studies: Some studies' estimates exhibit a peak during the financial crisis (Adrian and Wu, ; Kajuth and Watzka, ; Abrahams et al ., ; Pflueger and Viceira, ), whereas other studies report a drop of the inflation risk premium during this time (Hördahl and Tristani, ; Auckenthaler et al ., ; Andreasen et al ., ). And yet others find the premium to be permanently rather stable (D'Amico et al ., ).…”

“…The paper by Auckenthaler et al . () does not use the break‐even inflation rate but rather builds on the work of Campbell and Shiller () by calculating hypothetical ILB yields. These synthetic ILB yields are compared with their observed counterpart, and in the case of no premia at all, the difference between hypothetical and observed yields should be zero.…”

“…Auckenthaler et al . 's () minimum liquidity premium refers to 2008Q1 before the bankruptcy of Lehman Brothers. Kajuth and Watzka's () estimates refer to their model 1.…”

“…Söderlind (), Auckenthaler et al . () and Pflueger and Viceira () apply regression‐based approaches for the USA (see main text) as well as for the United Kingdom and/or the euro area. Kanas () presents a slightly different approach by additionally using bond futures.…”