TIPS, the Dual Duration, and the Pension Plan

Abstract

ot long ago, when the real yield (that is, the yield before adding the inflation adjustment) on Treasury InflationIndexed Securities (formerly called Treasury Inflation-Protected Securities, TIPS) exceeded 4 percent, investors could be forgiven for thinking that TIPS were the magical asset. At that time, it was not clear whether equities (much less nominal bonds) offered prospective real returns higher than 4 percent. So, TIPS offered not only inflation protection and the repayment of nominal principal (if one bought TIPS that were selling close to par) but a rich absolute return.Investors did not figure out the special attractiveness of TIPS for a while after the initial issuance of these securities, but apparently they did so in droves beginning in early 2000: The real yields on these instruments fell from a high of 4.36 percent in January 2000 to a low of 1.03 percent in March 2004.1 At today's more modest real yields, the case for TIPS is not one of timing or undervaluation but of structural advantage. One should ask: What are the characteristics of this instrument that make it fundamentally different from other securities? Who is the natural clientele for these characteristics; that is, for what kinds of investors are TIPS so attractive that it is rational for them to outbid others to acquire TIPS? Conversely, what kinds of investors should avoid TIPS?To answer these questions, we focus on the fact that, as Leibowitz, Sorensen, Arnott, and Hanson (1989) pointed out, an asset or stream of cash flows (in their case, equities) can be regarded as having two durations-(1) an inflation duration, D i , or sensitivity of the asset's return to a change in the inflation rate, and (2) a real-interest-rate duration, D r , or sensitivity of the asset's return to a change in the real interest rate. Although this distinction can, in principle, be drawn with nominal bonds, for such a bond, D i and D r are essentially equal to one another and also equal to the regular, or nominal, duration. The distinction between D i and D r becomes interesting when applied to TIPS, for which D i is emphatically not equal to D r , and to other assets, to liabilities, and to portfolios with the same characteristic.After exploring this "dual duration" characteristic of TIPS, we draw on Goodman and Marshall's (1988) observation that pension liabilities also have such a dual duration. We develop this parallel to show how TIPS can be used, together with nominal bonds, to hedge the inflation and real-interest-rate risks of pension liabilities. Finally, noting that equities also have an inflation duration that is different from their real-interestrate duration, we address the question of how to manage the asset class exposures in pension plan, foundation, and endowment fund portfolios and in the investment programs of individuals. 2 Because TIPS play into investors' natural desire to hedge against inflation and because of economists' special fondness for a security that provides a direct market measure of the real rate of interest, TIPS have re...

Strategic asset allocation for a country: the Norwegian case

“…The duration decreases over time. Both Goodman and Marshall (1988) and Siegel and Waring (2004) have 26 One can measure the duration of a bond, D r with respect to the key factor, real interest rates, r. Specifically, modified duration is given by:…”

“…Before looking at the duration for nominal bonds, recall the connection between nominal interest rates n, expected inflation rate π , and the real interest rate r; n = π + r. As pointed out by Siegel and Waring (2004), for nominal bonds the three duration definitions are approximately equal, D n ≈ D π ≈ D r . For the price of a nominal bond it is the same whether the change in interest rate arises from changes in inflation or changes in real interest rate.…”

Performance measurement for pension funds

“…In order to analyze assets and liabilities, we follow Siegel and Waring (2004) who consider the sensitivity of bonds relative to changes in the real rate and in the inflation expectations 4 . Phoa (1999) finds that using nominal duration for inflation-linked bonds gives misleading results.…”

“…A meaningful approach is to make a distinction between the real rate duration and the inflation duration. Using Fisher's decomposition of interest rates, Siegel and Waring (2004) derive duration measures that capture the sensitivities for both changes in inflation and real rates, the socalled 'dual duration concept'. In the analysis of Siegel and Waring, expected inflation and the inflation risk premium are considered as one.…”

TIPS, the Triple Duration, and the OPEB Liability: Hedging Medical Care Inflation in OPEB Plans

“…So, while Siegel and Waring illustrated that any point on the Inflation Duration-Real Interest Rate Duration plane can be achieved with long and short leveraged portfolios of nominal bonds and TIPS, in fact any point on that plane can be reached without even using nominal bonds. 15 Siegel and Waring (2004) observed "Finally, Figure 3 shows that short selling of nominal bonds or TIPS or both when combined with the use of leverage makes any desired combination of D i and D r achievable…of course, nobody really invests this way, but the conclusion is too appealing to pass over without mentioning." At the time, the CPI swaps market was fledgling, but now investors really can invest this way.…”