SS08: TIPS

[tulkuu]

1, Why is TIPS viewed as a separate asset class?
2, Why is TIPS’ coupon is Deflation Unprotected, while the coupon of a nominal fixed-coupon bond is Deflation Protected?
TIA.

 

[cpk123]

1. Homogenous -> similar rates of return across the entire maturity span of 10-20 years
2. Low correlation with other bonds and equity - Diversifying
3. Mutually Exclusive - Different properties from nominal bonds, and equities. (these are real bonds).
Interest - Deflation Unprotected, Inflation Protected.
Principal - Deflation Protected (Partial), Inflation Protected.
Equities - lose value during inflation …
4. Preponderance of investable wealth -> not found evidence for this anywhere. (possibly present)
5. Liquid (Issued by US Govt ….?)
Given 4 out of 5 are covered … (of the necessary asset class attributes - I would say yes).

 

[cpk123]

Coupon of a Fixed Nominal Bond - pays 5% Coupon on Principal - no matter what the inflation condition is. When inflation level goes down - you still get your 50$ coupon - (at face value) - so you essentially have higher $ after adjusting for inflation.
Coupon of TIPS - Principal value would shift downwards - and you get a fixed amount of that new (adjusted) principal. So in today’s $ you received less [not sure if this is right].

 

[FinNinja]

I assume the question is why aren’t real return bonds and nominal bonds in the same asset class?
First what criteria help to specify asset classes:
1. asset classes should be homogeneous - granted these are both bonds, but then again so are domestic bonds and global bonds and they are separated, so I don’t think this argument holds. they may be different enough to separate.
2. Asset Classes should be mutually exclusive - these two groups can be separated by a distinct line. if a bond is a real return bond - it is not a nominal bond. There is no bond that falls partly in each type.
3. Asset classes in aggregate should make up much of worlds investible wealth - by separating we do not affect this criteria
4. Asset class should have the ability to absorb a large portion of a portfolio without affecting liquidity - this also would not be affected by separating real return bonds out since they are highly liquid instruments
5. Asset classes sould be diversifying; low correlation b/w - these two groups do have low correlations between them as real return bonds will hold their values in volatile interest rate environments while nominal bonds will not.
Looking at all of these characteristics of asset classes, I don’t see any reason why they couldn’t be separated. Also given the last one about diversification b/w asset classes I’d say they should be separated.

 

[cpk123]

Homogenous - they explain that in a blue box in the text - by saying that similar returns are seen on these across a 10-20 year maturity span.