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INFLATION INDEXED SECURITIES: A USER’S PERSPECTIVE

INFLATION INDEXED SECURITIES: A USER’S PERSPECTIVE. Presented at Boston QWAFAFEW, March 1998. Ron D’Vari, Ph.D.,CFA. AGENDA. ANATOMY OF NOMINAL INTEREST RATES FACTORS INFLENCING INFLATION EXPECTATIONS REVIEW OF TIPS AND CIPS (STRUCTURE, HISTORY,ETC.) PROS AND CONS OF TIPS

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INFLATION INDEXED SECURITIES: A USER’S PERSPECTIVE

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  1. INFLATION INDEXED SECURITIES: A USER’S PERSPECTIVE Presented at Boston QWAFAFEW, March 1998 Ron D’Vari, Ph.D.,CFA

  2. AGENDA • ANATOMY OF NOMINAL INTEREST RATES • FACTORS INFLENCING INFLATION EXPECTATIONS • REVIEW OF TIPS AND CIPS (STRUCTURE, HISTORY,ETC.) • PROS AND CONS OF TIPS • REAL VS NOMINAL RISK MEASURES • TIPS VALUATION AND BREAKEVEN ANALYSIS • US CPI-URN-NSA HISTORICAL PERFORMANCE • TACTICAL VS STRATEGIC USE OF TIPS/CIPS TIPS, Ron D'Vari

  3. ANATOMY OF NOMINAL INTEREST RATES EXPECTED REAL RATE RISK PREMIA EXPECTED INFLATION LESS CONVEXITYBIAS UNEXPECTED INFLATION PREMIUM OTHER RISKS’ PREMIA UNEXPECTED REAL RATE PREMIUM LIQUIDITY CREDIT ETC TIPS, Ron D'Vari

  4. ANATOMY OF NOMINAL INTEREST RATES REAL RATE = EXPECTED REAL + UNEXP. REAL PREMIUM - REAL CONVEXITY BIAS + LIQUIDITY PREMIUM BEIIR = EXPECTED INFLATION + UNEXP. INFLATION + (REAL-NOMINAL) CONVEXITY BIAS - REAL LIQ. PREM. TIPS, Ron D'Vari

  5. FACTORS INFLUENCING INFALTION EXPECTATIONS MONETARY & FISCAL POLICIES ECONOMIC GROWTH TRADE POLICIES/ BARRIERS DOMESTIC INTERNATIONAL CURRENCY REGIMES/POLICIES CAPITAL GOODS INVESTMENT PRODUCTIVITY GROWTH GLOBAL COMPETITION LABOR MARKETS GOODS MARKETS TIPS, Ron D'Vari

  6. CURRENT DRIVERS OF LOW INFLATION • HIGHER CONFIDENCE ON US MONETARY AND FISCAL POLICIES • Global emulation of US economic policies • STRONG US DOLLAR (LOW IMPORTED INFLATION) • Southeast Asia new free currency regime • Yen’s further weakening • PRODUCTIVITY IMPROVEMENTS • Computer technology payoffs • Investments in capital equipment • GLOBAL EXCESS CAPACITY • LOWER TRADE BARRIERS • Increased global competition • Low pricing power • RISKS: Low unemployment, increased union power, inflated financial asset prices TIPS, Ron D'Vari

  7. VARIOUS STRUCTURES • POSSIBLE INFLATION-LINKED STRUCTURES • Interest Indexed (less inflation protection) • Capital Indexed (more inflation protection) • Zero-coupon Indexed (most inflation protection) • Indexed Annuity • MOST DESIRABLE : Capital Indexed • 3.375% Real Coupon, Actual/Actual, Semia Annual (SA) • Nominal SA Coupon Payaouts Original Par Amount * (Index Ratio on Coupon Date) * ( 3.375%)/2 • Current Principal = Indexed to CPI (accretes with CPI-U) At maturity it is Max (100 * CPI-U Index/Ref Index, 100) TIPS, Ron D'Vari

  8. Nominal Price is a function of past inflation not future inflation (3-Month Lagged CPI-U Index on Settlement Date) • Index Ratio = ---------------------------------------------------------------------- ( 3-Month Lagged CPI-U Index on Issuance Date) • Price/Yield calculation is done in real domain and converted to nominal by the index ratio TIPS, Ron D'Vari

  9. OTHER ISSUES • Revisions to CPI Calculation Methodology - Uncertain • Can be lower as much as 0.5%/Year • More an issue with 10- and 30-years than 5-year • Stripping Has Been Clarified • Coupon and principal strips of different bonds are combinable • Different bonds different reference index ratios • For tax purposes, strips will be treated as OID • No stripping has yet occurred • Trading Practices - Straightforward • PSA a "Trading Practice Guidelines • Price and quotation on real basis • Settlement price is adjusted based on settlement index ratio • Forward pricing beyond a month is problematic TIPS, Ron D'Vari

  10. DERIVATIVES PRICING • Forward Pricing Analysis • Cost of Carry Analysis • Buy/Sell Back Repo Analysis • Inflation Indexed Bond Futures • CPI-U Swap Analysis • CPI-U Linked Options TIPS, Ron D'Vari

  11. US TIPS: A BRIEF HISTORY • TIPS’ BASIC STRUCTURE • Principal adjusted daily based on 3-m lagged index ratio • Index = NSA CPI-U (all items for all urban consumers) • Nov. 96 ==> Feb 1, 97 and Dec. 96 ==> March 1, 97 • Linearly interpolated in between • Principal adjustments are not paid out periodically • (treated like a zero - compounds daily) • Semi-annual coupon (real) based on adjusted principal • 100% of Original Principal is Guaranteed at Maturity • Prin. At Maturity = Max [Orig. Prin. , Orig. Prin. x Index Ratio at Mat.] • CAN BE STRIPPED • DRAWBACKS OF US TIPS STRUCTURE • Principal Appreciation Taxed Annually • Can lead to negative nominal cash flows (high inflation) • Less attractive for taxable entities such as retail investors TIPS, Ron D'Vari

  12. US TIPS: A BRIEF HISTORY • ISSUANCE • QUARTERLY SINGLE-PRICE AUCTIONS • 5YR: 7/97 for $8.4Bil, 10/97 for $8.0Bil (Mat 7/02) • 10YR: 1/97 for $7.6Bil, 04/97 for $8.4Bil (Mat 1/07) • 1/98 for $8.0Bil, 10/98 for $8.0Bil (Mat 1/08) • 1/99 for $7.0Bil, (Mat 1/07) • 30YR: 4/98 for $8.0Bil, 07/98 for $8.0Bil (Mat 4/28) • 4/99 for $6.0Bil (Mat 4/29) • INITIAL AUCTION WAS VERY SUCCESSFUL • (Bid/Cover of 5.2 at Real Yield of 3.44%) • LACKLUSTER RETAP OF 10-YR AND 5-YR AUCTIONS • US TREASURY HAS EXPRESSED ITS COMMITMENT • TO THE TIPS PROGRAM TIPS, Ron D'Vari

  13. US TIPS: AUCTION HISTORY • LIQUIDITY • HAS BEEN INLINE WITH EXPECTATION SO FAR • EXPECTED TO INCREASE WITH ISSUANCE • IN FUTURE YEARS CAN BE AS MUCH AS 30% OF • NEW COUPON ISSUANCE • WILL SOON SURPASS ANY OTHER FOREIGN I/L • MARKETS TIPS, Ron D'Vari

  14. CPI-URN SEASONAL EFFECT TIPS, Ron D'Vari

  15. CPI-URN-NSA TREND TIPS, Ron D'Vari

  16. SHORT REAL RATE TREND TIPS, Ron D'Vari

  17. CPI-U NSA PAST PERFORMANCE • 20 YR=4.95%, 10-YR=3.54% , 5-YR=2.68%, 3-YR=2.57% 1-YR=2.23% TIPS, Ron D'Vari

  18. CORPORATE, AGENCY, AND MUNIES ISSUANCE • SOME CORPORATE ISSUANCE • TVA, $300MM, 10-YR • FHLB, $200MM, 10YR • JP Morgan, $200MM, 15YR • Salomon Brother, $400MM, 5YR • Toyota Motor Credit, $100MM, 5YR • HAS SLOWED SIGNIFICANTLY • RELATED ISSUES • Advantages and Disadvantages From Issuer Perspective • - Diverse motivation for Issuance • Alternative to Short Term or Long Term Debt? • Hedged vs. Unhedged Issuance • VALUATION ISSUES • Total Inflation Protection vs. Non -Accretion • Relative Value Analysis for Different Structures • MIPS (Munis) PROTECTED FROM INFLATION AND TAXES • Before-tax yields are very low (CPI+1%) • Only riskless asset? TIPS, Ron D'Vari

  19. REAL VS NOMINAL RISK MEASURES TIPS, Ron D'Vari

  20. NOMINAL HEDGES CAN BE IMPERFECT TIPS, Ron D'Vari

  21. 5YR TIP’S RISK TIPS, Ron D'Vari

  22. 10-YR TIP’S RISK TIPS, Ron D'Vari

  23. 30YR TIP’S RISK TIPS, Ron D'Vari

  24. 5YR Vs 10YR TIPS’ Historical Yield Spreads TIPS, Ron D'Vari

  25. 5YR Vs 10YR TIPS’ Yield History TIPS, Ron D'Vari

  26. 5Yr Vs 10Yr TIPS’ Price Regression TIPS, Ron D'Vari

  27. 5Yr Vs 10Yr TIPS’ Yield Regression TIPS, Ron D'Vari

  28. 5-YR TIPS VALUATION TIPS, Ron D'Vari

  29. 5-YR TIPS VALUATION TIPS, Ron D'Vari

  30. 10-YR TIPS VALUATION TIPS, Ron D'Vari

  31. 10-YR TIPS DURATION BASED ONSCENARIO ANALYSIS TIPS, Ron D'Vari

  32. PORTFOLIO USE • STRATEGIC • DIVERSIFICATION • REDUCED RISK • HIGHER SHARP RATIO • REDUCE RELATIVE RISK (NOT VALID ANYMORE) • TIPS WERE INCLUDED IN LEHMAN AGGREGATE INDEX UNTIL 12/31/97 • LIABILITIES INDEXED TO INFLATION • TACTICAL • ENHANCE RELATIVE PERFORMANCE DUE TO - UNANTICIPATED REAL GROWTH SLOW DOWN - UNANTICIPATED INFLATION PICK UP (LESS SO) • BUY INTEREST RATE PROTECTION CHEAP TIPS, Ron D'Vari

  33. Piet M.A. Eichholtz, ET. AL, Journal of Fixed Income, December of 1993 • UK: January 1983 to December 1992 • Israel: January 1984 through May 1992 • Used Cash, Nominal and IL Bonds/Bills and Equity • Considered both low and high levels of risk tolerance TIPS, Ron D'Vari

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