Government Bond Research

Risk Characteristics of TIPS Compared to Nominal Treasury Securities

May 1997 Prashant Vankudre (212) 526-8380 Peter Lindner (212) 526-0585

Summary
We derive empirical hedge ratios for TIPS, using a minimum variance portfolio approach. We find that the optimal empirical hedge portfolio contains 46.2% cash, 22.0% of the 5-year, and 31.8% of the old 10-year. We estimate the nominal duration of 10-year TIPS to be 3.13 years. If investors expect future inflation to be contained, we advocate hedging the 10-year TIPS with 10-year nominal Treasuries, using real duration of the TIPS. We show that such a strategy would have worked well over the period from January 30 to April 30, 1997.

Government Bond Research Strategies Doug Johnston Nitsan Hargil Stuart Sparks Prashant Vankudre Ralph Axel Peter Lindner Phil Weissman Julio Maclay Ronald Grobel Alan Rojer 212-526-6566 212-526-5566 212-526-6566 212-526-8380 212-526-5573 212-526-0585 212-526-0697 212-526-7419 212-526-1340 212-526-6701

Modelling

Analytics

We would like to thank Ralph Axel, Lev Dynkin, Doug Johnston, Julio Maclay, and Ravi Mattu for helpful discussions.
Publications: M. Parker, D. Marion, V. Gladwin, A. DiTizio, C. Triggiani, B. Davenport. This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. The information in this document has been obtained from sources believed reliable, but we do not represent that it is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. 1997 Lehman Brothers Inc. All rights reserved. Member SIPC.

The inclusion of 10-year Treasury Inflation-Protection Securities (TIPS) in the Lehman Brothers Government Index has fueled interest in the risk characteristics of these securities compared to nominal Treasuries. Enough trading history is now available to allow a preliminary estimation and discussion of these risk characteristics. For evaluating short-term TIPS performance, we recommend a minimum variance portfolio approach to determining the combination of nominal securities that most closely approximates the price risk of TIPS. Based on daily yield changes over the 60-day trading period ended April 30, 1997, this minimum variance portfolio of nominal securities consisted of 46.2% in cash, 22.0% in the 5-year, and 31.8% in the old 10-year. The minimum variance portfolio still contains a substantial amount of residual risk. The hedged version of this portfolio is projected to leave unhedged 38% of the price variance of TIPS, an amount of basis risk that is greater than most Treasury investors experience. Therefore, our recommended approach is likely to be most useful to indexed investors who need to know the average risk characteristics of TIPS.1 Investors interested in a summary measure of risk can use the modified duration of the minimum variance portfolio of nominal Treasuries. This is the measure that will appear as the nominal duration of TIPS in the Lehman Brothers indices in the future. Currently, only real durations are reported. The basis risk of single security hedges based on nominal duration will be greater than that of the hedge based on a minimum variance portfolio. The nominal duration of the TIPS using a minimum variance portfolio approach is 3.13 years. The minimum variance portfolio depends on the correlations between price returns of nominal Treasuries and TIPS, which in turn depend on economic fundamentals (see the Lehman Brothers report, Treasury Inflation-Protection Securities: Opportunities and Risks,
1

January 1997). As these fundamentals change, the risk characteristics of TIPS will also change. We calculate correlations using the most recent 60 days of trading history. The empirically estimated risk characteristics, therefore, are most applicable for short horizons because the near-term future correlations are likely to be similar to the recent past. As the horizon extends, the projected risk characteristics can change substantially; views about the probable economic environment are likely to be a better guide to the future risk characteristics of TIPS. In our view, this subjectivity is unavoidable and represents a departure from the customary risk considerations of most Treasury investors.

MINIMUM VARIANCE HEDGE

To construct the minimum variance portfolio, we first estimate the correlations of daily yield changes of TIPS and the 3-, 5-, old 10-(6.5% of October 2006), and 30-year. We use 60 trading days of history through April 30, 1997 in our calculations. Figure 1 shows the correlation matrix. The correlations of TIPS with nominal bonds are all about 0.77, and the maximum is with the 10-year. We also estimate the yield volatilities of these securities (volatility of real yields for TIPS). Figure 2 shows the annualized yield and price volatilities of the securities.
Figure 1. Correlations of Yield Changes of Nominal and Inflation-indexed Treasuries
Daily data, January 30-April 4,1997 Nominal 5-yr 10-yr 0.99 0.97 1.00 0.99 1.00 Inflation -indexed 10-yr 0.76 0.78 0.79 0.77 1.00

Nominal 3-yr 5-yr 10-yr 30-yr Inflationindexed 10-yr

3-yr 1.00

30-yr 0.94 0.96 0.99 1.00

Figure 2.

Estimating the correlations over a longer interval such as a week, instead of daily, is unlikely to improve hedging performance. The currently available trading history is insufficient to produce statistically defensible numbers from weekly observations. When we estimated correlations using weekly observations, the results were very sensitive to the time period covered. Setting the starting date for computation of weekly correlations at February 4, 1997 leads to reduced correlations of the TIPS with the nominal Treasuries compared to daily data, whereas setting the starting date at January 30, 1997 leads to much higher correlations.

Volatilities of Yield Changes and Price Returns of Nominal and Inflation-indexed Treasuries (Annualized)
Price Volatilities 1.95% 3.41 5.29 8.61 3.08

Sector Yield Volatilities 3-yr. 0.78% 5-yr 0.81 10-yr 0.76 30-yr 0.69 Inflation-indexed 10-yr 0.38

Lehman Brothers

May 1997

From the correlations and yield volatilities we construct the covariance matrix of price returns using the current durations of the securities (real duration for TIPS). Next, we form a zero investment portfolio of cash and nonnegative holdings in the 3-, 5-, old 10-, and 30-year and -100% holding in TIPS. This is equivalent to constructing an asset-liability portfolio with nominal Treasuries as the assets and TIPS as the liability. The inclusion of cash is incorporated by not requiring the holdings of nominal coupon Treasuries to add up to 100%. If nominal Treasuries are less than 100%, then the remaining amount is invested in cash; conversely, nominal holdings of more than 100% are a result of borrowing cash. Minimizing the variance of return of this asset-liability portfolio leads to the portfolio of nominal securities that is closest to TIPS in its risk characteristics. Based on daily yield changes over the 60 trading day period ended April 30, 1997, the minimum variance portfolio of nominal securities consisted of 46.2% in cash, 22.0% in the 5-year, and 31.8% in the old 10-year. We measure the efficiency of the minimum variance hedge as one minus the ratio of variance of price returns for the minimum variance portfolio and TIPS. The minimum variance hedge portfolio has a standard deviation of price returns of 95 bp (quarterly) compared to 154 bp for TIPS. The hedge efficiency expressed as a variance ratio, therefore, is 62% [ i.e., 1 - (95/154)2].2 Our method is similar to multivariate regression hedging (i.e., empirical duration hedging) with the regression coefficients constrained to satisfy the requirement for non-negative holdings of nominal coupon securities. The difference is that we compute the covariance matrix of price returns underlying the minimum variance problem using the covariance matrix of yield changes, multiplying them with the current durations of the instruments. Empirical durations are usually computed by regressing price returns on yield changes so that the results depend on historical average durations. Our method avoids using durations that are outdated due to passage of time and changes in yield level.

We also consider the sensitivity of hedge efficiency to changes in portfolio composition. Given the high correlations among nominal Treasuries, different hedge portfolios can have similar hedge efficiencies. For example, a portfolio consisting of only 25.5% in the 30-year and the rest in cash is expected to have a hedge efficiency of 59%; a portfolio of 132.7% in the 3-year and 32.7% of borrowed cash has a hedge efficiency of 57%. Although these portfolios are vastly different, their hedge efficiencies are close to the 62% efficiency of the minimum variance hedge.3

NOMINAL DURATION OF TIPS

The minimum variance portfolio of nominal Treasuries most closely approximates the risk characteristics of TIPS. Investors interested in a single measure of risk can use the modified duration of the minimum variance portfolio as the nominal duration of TIPS. In the example above, the duration of the minimum variance portfolio is 3.13 years. The nominal duration of TIPS to be reported in our indices will be calculated by this method. Hedges using the nominal duration will have greater basis risk than those formed using the minimum variance portfolio. For example, TIPS could be hedged with a bullet Treasury with the same duration as the nominal duration of TIPS. The choice of nominal duration for hedging will depend on a particular investors tolerance for basis risk.

LONGER TERM CONSIDERATIONS

Our method is likely to be effective in projecting the risk characteristics of TIPS over the near term, but a substantial amount of basis risk remains. Projecting risk characteristics over the longer term is more problematic. Correlations between inflation expectations, risk premia, and real yields depend on economic fundamentals. The correlations will change as the fundamentals change, as the analysis of inflation-indexed Gilts in our January report showed.

2We measure hedge efficiency using variance rather than standard deviation since risk expressed as variance is additive, but not when expressed as standard deviation. For example, the ratio of standard deviation of price returns for the minimum variance portfolio and TIPS is 62%, but the proportion of standard deviation explained by the hedge is 79%.

3Similarly, small changes in the covariance matrix, e.g., due to the addi-

tion of one new data point, can lead to substantial changes in the minimum variance portfolio.

Lehman Brothers

May 1997

In the U.S., the period since the issuance of TIPS has been characterized by a robust economy with the Federal Reserve Board active in controlling inflation. Although actual inflation has been low, the Fed has already tightened once. In this environment, real yield of TIPS has been about half as volatile as the yield on the old 10-year (based on daily yield changes). However, a portfolio manager will ask what the real yield of TIPS might be relative to the old 10-year yield by year-end. If the Fed succeeds in convincing the market of its ability to keep inflation low, inflation expectations and inflation risk premia should revert to their levels before inflation fears affected the market. In that case, by year-end real and nominal yields would move about the same amount, implying that the nominal duration of TIPS would equal their real duration. This means that on a forward looking basis the correlation matrix of yield changes will be different from that estimated using past data. Investors who think nominal yield changes are primarily driven by changes in risk premia or inflationary expectations will say that real yields do not move much. Therefore, if the 10-year to TIPS spread ends the year at its current value, nominal as well as real yields will be approximately where they are now. Thus, duration becomes irrelevant. This position assumes that the real rate has little or no volatility. We showed in our January report that real activity can be a significant contributor to real as well as nominal rate changes. The annualized real rate volatility based on daily TIPS prices is 38 bp, i.e., there is about a one-third probability of real rates being more than 40 bp away from current rates. Furthermore, a similar change in 10-year real and nominal yields can occur even though daily data suggest that the nominal duration of TIPS is much shorter. Even the short history of TIPS so far illustrates this point. For example, from the close of business on 2/28/97 (two days after Federal Reserve Board Chairman Greenspans Humphrey-Hawkins testimony before Congress) to 4/15/97 (when a market friendly CPI report was published), the old 10-year yield increased by 32 bp, from 6.59% to 6.91%. Over the same period, the TIPS yield increased by 30 bp, from 3.34% to 3.64%. This is an almost one-for-one move of real and nominal rates in an environment seemingly dominated by inflation fears. This occurred during a period when daily data indicate a nominal duration of TIPS of close to three years.

Any investor who viewed TIPS as a 3-year nominal duration security would have experienced serious underperformance of the hedge. Figure 3 shows hedging performance from 1/30/97 to 4/30/97. An investment of $100 in TIPS would have resulted in a loss on principal of $1.82. Computing a hedge ratio based on the covariance matrix of yield changes over the whole period, and using the durations on 1/30/97, produces a hedge ratio of 0.57 using the 6 1/2 of 10/15/06 (old 10-year). Shorting $57 of the old 10-year leads to a gain on the hedge of $0.57. The hedged position therefore loses $1.25 per $100 invested in the TIPS. A simple duration hedge of the TIPS with the old 10-year would have led to a gain in the hedge of $1.20, and therefore a total loss in the hedged position of $0.62 per $100 invested in the TIPS.4 This remaining difference can be almost completely accounted for by contraction in the spread between the TIPS and the 10-year of about 7 bp. Using the 5-year note for hedging (with the appropriate hedge ratio) leads to a small improvement in hedging performance over the period. The gain on the hedge is $0.65 per $100 invested in the TIPS, still a substantial underperformance compared to duration hedging with the old 10-year. Empirical ratios for hedging TIPS can be useful in environments where the investor does not want to make forecasts about future inflation. Investors need to be aware that in the world of TIPS, the same data can support seemingly contradictory results. Economic insights could be more valuable than pure statistical analysis.
4Hedge

ratio=Real duration of TIPS/Duration of old 10-year.

Figure 3.

Hedged Performance of TIPS versus 5- and 10-year, 1/30/97-4/30/97

Hedge Gain/(Loss) Gain/(Loss) Net Gain/ Ratio (per $) on TIPS (%) on Hedge (%) (Loss)

Duration Hedge with 10-year Empirical Hedge with 10-year Empirical Hedge with 5-year

1.20 0.57 0.71

(1.82) (1.82) (1.82)

1.00 1.00 0.92

(0.62) (1.25) (1.17)

In the Gain/Loss computations above, we do not consider differences in coupons, repo rates, and anticipated or realized gains on the TIPS due to inflation.

Lehman Brothers

May 1997