The Microstructure of the TIPS Market

There is wide consensus among financial economists that returns on nominal U.S. Treasury bonds in excess of Treasury bills are predictable at different investment horizons. Predictor variables include forward rates (Fama and Bliss, 1987), the slope of the yield curve (Campbell and Shiller, 1991), and a linear combination of forward rates (Cochrane and Piazzesi, 2005). There is however an ongoing discussion about what drives this predictability. We contribute to this discussion by conducting a joint empirical analysis of the sources of excess bond return predictability in nominal and inflation-indexed bonds in the U.S. and the U.K. Specifically, we provide evidence that both time-varying inflation risk premia and time-varying real interest rate risk premia are quantitatively important in explaining time variation in the expected excess return on nominal bonds. The question whether expected excess returns of inflation-indexed bonds are time-varying is important on its own. It remains relatively unexplored, partly due to the short history of U.S. inflation-indexed bonds (Campbell, Shiller, and Viceira, 2009). We contribute to the emerging research on inflation-indexed bonds by examining and distinguishing among three potential sources of excess return predictability in inflation-indexed bonds: time-varying real interest rate risk, timevarying liquidity risk, and market segmentation. Our work differs from recent work on inflationindexed bond return predictability by Campbell, Sunderam, and Viceira (2013) and Pflueger and Viceira (2011) in that it finds and corrects for an economically significant liquidity risk premium, which otherwise would likely distort estimates of real rate and inflation risk premia. Novel and unique to our work is the finding that a liquidity component in breakeven inflation, or the spread between nominal and inflation-indexed bond yields of similar maturity, predicts the return differential between nominal and inflation-indexed bonds due to liquidity. The estimated U.S. return differential due to liquidity exhibits a significantly positive stock market CAPM beta, suggesting that U.S. TIPS investors bear systematic liquidity risk and should be compensated in terms of a positive return premium. While the return differential due to liquidity is not directly 1 tradable, this result is relevant to investors who may differ in terms of their exposure to liquidity crises. Research in financial economics has proposed several theories to explain predictability in nominal excess bond returns. One hypothesis is that excess return predictability results from time variation in the aggregate price of risk. Building on the habit preferences model of Campbell and Cochrane (1999), Wachter (2006) shows that a model with time-varying real interest rates can generate nominal bond excess return predictability. Second, excess return predictability could result from time variation in expected aggregate consumption growth or its volatility. The long-run consumption risk model of Bansal and Yaron (2004) and Bansal, Kik...

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“…TIPS. Fleming and Krishnan (2009) also provide evidence that trading activity is a good measure of cross-sectional TIPS liquidity.…”

Section: Estimating the Liquidity Differential Between Inflation-imentioning

confidence: 80%

“…For additional evidence of relatively lower liquidity in U.S. TIPS, seeCampbell, Shiller, and Viceira (2009),Fleming and Krishnan (2009),Dudley, Roush, and Steinberg Ezer (2009), Gurkaynak, Sack, and Wright (2010),Christensen and Gillan (2011).…”

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confidence: 99%

Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Pflueger

Viceira²

2016

Handbook of Fixed‐Income Securities

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“…While the off‐the‐run to on‐the‐run yield spread suggests that the Treasury market dislocations were concentrated in the first few months after the Lehman failure, other measures suggest that liquidity in the Treasury market may have been impaired for a longer period of time. Figure 9 shows the trading volume in nominal and real Treasury bonds from January 2003 to December 2009, which Fleming and Krishnan (2009) argue provides a useful measure of market liquidity. While the levels of the smoothed weekly trading volumes are quite different across the two markets, they both exhibit a similar sustained decline after the Lehman bankruptcy.…”

Section: Analysis Of the Recent Financial Crisismentioning

confidence: 99%

Inflation Expectations and Risk Premiums in an Arbitrage‐Free Model of Nominal and Real Bond Yields

Christensen

López

Rudebusch

2010

J of Money Credit Banking

198

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Differences between yields on comparable-maturity U.S. Treasury nominal and real debt, the so-called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums from the BEI rates. We provide such decompositions using an estimated affine arbitrage-free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long-term inflation expectations have been well anchored over the past few years, and inflation risk premiums, although volatile, have been close to zero on average. † We thank participants at the FRB/JMCB conference for helpful comments, especially our discussant Stanley Zin, as well as the editors and referees. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal

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“…See an analysis of the Treasury inflation-protected securities marketMichael Fleming and Neel Krishnan (2012) 3 See Riksbank's Risk Surveys since 2015 published on Riksbank's website www.riksbank.se 4 Survey on credit terms and conditions in euro-dominated securities financing and OTC derivatives markets (SESFOD). The June 2016 survey can be found at: https://www.ecb.europa.eu/press/pr/ date/2016/html/pr160711.en.html…”

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confidence: 99%

Quantitative Easing and the Price-Liquidity Trade-Off

2017

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We present a search theoretic model of over-the-counter debt with quantitative easing (QE). The impact of central bank asset purchases on yields depend on market tightness, which is determined by shares of preferred habitat investors. The model predicts that the impact of government bond purchases is higher in countries with a higher share of preferred habitat investors. Furthermore, there is a trade-off with liquidity, which is not present in other models of QE. We present a new index for the share of preferred habitat investors holding government bonds in Eurozone countries, based on the ECB's securities and holdings statistics, which we use to match the impact of QE on the observed yield changes in data and to test our model.

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The Microstructure of the TIPS Market

Cited by 24 publications

References 25 publications

Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity

Inflation Expectations and Risk Premiums in an Arbitrage‐Free Model of Nominal and Real Bond Yields

Quantitative Easing and the Price-Liquidity Trade-Off

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