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We derive an expression for TIPS bond yield spreads. Our spread is based on a TIPS bond pricing model that accounts for an option embedded in these bonds. This option guaranties that bondholders are not adversely affected by deflation. We demonstrate that the determinants of TIPS bond spreads include the real (option-free) bond return volatility, the nominal rate, the real rate, and the bond's time to maturity. An empirical test provides strong support for the comparative statics provided for these determinants. [G11]
Fixed-income markets worldwide offer bondholders protection against inflation by introducing inflation-linked bonds. Countries that issue these bonds include Australia, Canada, Israel, New Zealand, Sweden, the United Kingdom, and the United States. Wilcox (1998) reports that as of mid-1997, the UK issued the highest aggregate volume of inflation-indexed debt (US$71.1 billion). Israel ranked second (US$27.9 billion), then the US (US$15 billion), Sweden (US$5.7 billion), Canada (US$4.3 billion), Australia (US$2.7 billion), and New Zealand (US$0.1 billion).
The US market for inflation-linked bonds has increased rapidly in recent years and it is now the largest in the world. The August 2005 report prepared by the Office of Debt Management at the Department of the Treasury states that as of July 2005, the US Treasury was the largest issuer of inflation-linked bonds worldwide (with market capitalization of US$306 billion), and its size was close to 8% of the market capitalization of nominal Treasury securities. With an average daily volume exceeding US$8 billion, the US market for inflationlinked bonds is an active market that attracts significant attention by academics and practitioners.
The focus of our study is on the pricing and elasticity of US Treasury Inflation-Protected Securities (TIPS). We use our TIPS pricing model (Jacoby and Shiller, 2007) to provide a theoretically consistent expression for TIPS bond yield spreads that accounts for the value of the embedded option. Bond traders often use yield spreads to price TIPS bonds. Normally, traders apply a pricing algorithm that calculates a yield for the TIPS bond, which is tied to a benchmark Treasury yield with a spread. We use the yield-spread expression we derive from our pricing model to study the determinants of TIPS yield spreads, and we empirically test some of its implications.
The inflation adjustment for the TIPS...