Fixed Income Research

Valuing the Real Yield Curve

May 1998
Ralph Axel
(212) 526-5573
Douglas Johnston
(212) 526-6566
Alex Reyfman
(212) 526-7253
Prashant Vankudre
(212) 526-8380

Summary

• We value the real yield curve using two complementary models: one based on
the dynamics of the real short rate and the other based on correlations between
real and nominal yields. The trading history of the 30-year TIPS since its an-
nouncement has been consistent with our approach.

• Our models indicate that the recent inversion of the real curve is due to a rise in
the short real rate relative to a stable long-term real rate. The term structure
of inflation spreads moves inversely with the correlation between real and nomi-
nal yields.

• Our models imply that the real curve is likely to steepen if

- the Federal Reserve eases and/or inflation expectations rise;
- the correlation between real and nominal yields increases; or
- the volatility of real yields declines.
 Government Bond Research

Strategies Doug Johnston 212-526-6566

Stuart Sparks 212-526-6566
Steve Moulding 212-526-6566
George Oomman 212-526-6566

Modelling Prashant Vankudre 212-526-8380

Ralph Axel 212-526-5573
Peter Lindner 212-526-0585
Alex Reyfman 212-526-7253

Analytics Julio Maclay 212-526-7419

John Lu 212-526-6993
James Wang 212-526-6808

Publications: M. Parker, D. Marion, V. Gladwin, A. DiTizio, C. Triggiani, B. Davenport, J. Doyle

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Lehman Brothers 2 May 1998

On April 1, 1998 the U.S. Department of the Treasury
announced the auction of $8 billion of 30-year Treasury
Inflation Protection Securities (TIPS). In the April
issue of the Lehman Brothers report, U.S Government
Monthly Outlook, we said that fair value yield of
the 30-year TIPS, given market conditions, should be
5-15 basis points (bp) below the old 10-year TIPS
yield. The auction was held April 8 with the 30-year
receiving an average bid of 3.75%, about 11 bp below
the yield of the 3 3/8 of 1/15/07.
Since the only outstanding TIPS issues before the
30-year TIPS auction were the 5-year of 7/15/02, the
10-year of 1/15/07, and the 10-year of 7/15/07, projecting
the 30-year TIPS yield presented a challenge. With the
goal of determining fair value of the 30-year TIPS yield,
Lehman Brothers developed two complementary meth-
ods for analyzing the real yield curve and its relationship
to the nominal curve. The methods independently pro-
jected similar fair value yields. Since the auction, TIPS
trading has conformed to the projections of our models.
This report describes our methodology and provides a
historical perspective for our models.
Our first approach was to use the existing TIPS to project
fair value for the 30-year TIPS. We employed a one-
factor term structure model of the real curve that specifies
a mean-reverting process for the real short rate. The
model calibration procedure finds an implied short-term
real rate and a yield on a long maturity TIPS that are
consistent with the yields of existing TIPS.1 The implied
parameters are used to project the yield of the 30-year
TIPS. When applied over the pre-auction period, the
model produces estimates of implied short and long real
rates that are stable and intuitive. The implied long-term
real yield has been relatively stable at around 3.5% since
July 1997 while the implied short-term real rate has
increased from 3.7% to 4.1%. The negative spread
between the short and long rates reflects the inversion of
the real yield curve. The historical path of the model-
implied short-term real rate closely approximates the
empirical real rate, which we measure as the difference
between the 3-month general collateral rate in the repur-
chase market and actual inflation over the previous 12
months. This provides independent support for the model.
In the second approach, we evaluated the real curve
within the context of the nominal curve. The Treasury
1 The long maturity yield is the yield on a perpetual discount bond.
Lehman Brothers
market is dominated by nominal securities, and portfolio
managers will consider buying real securities only if their
risk/return trade-off compares favorably with that of nomi-
nal securities. We employ a two-factor model based on
Arbitrage Pricing Theory (APT) that takes into account
both the nominal and real term structures. The APT
model implies a linear relationship between expected
returns of securities and their loadings on the risk factors
affecting the returns. We assume all nominal securities
are exposed to a single common risk factor. Real
securities are exposed to this nominal risk factor but are
additionally affected by an independent risk factor. The
pre-auction projected yield of 30-year TIPS was derived
from an expected return that was consistent with the
pricing relationship implied by nominal securities and
5- and 10-year TIPS.
Results of our APT model conform to observed behavior
of real securities. The model implies that the shape of the
real curve will become more like that of the nominal curve
when the correlation between nominal and real securities
increases. This is borne out by the historical behavior of
the slope of the 5- to 10-year TIPS curve in relation to the
5- to 10-year nominal curve slope. The model can also be
used to determine an implied short-term inflation forecast
embedded in TIPS prices. This implied inflation has
mirrored actual inflation and accompanying economic
fundamentals throughout the period in which both 5- and
10-year TIPS have traded.
A REAL VIEW OF TIPS
To begin our analysis, we considered TIPS in purely real
terms. This approach neglects the fact that the bond
market thinks in nominal terms and views TIPS as a way
to hedge inflation. The benefit of considering TIPS
separately from the nominal world is the insight offered
into the market’s views on the real short- and long-term
rates. We apply Vasicek’s 1977 model to the real term
structure.2
One-factor equilibrium term structure models such as
Vasicek’s describe the current term structure based on
short rate dynamics. The Vasicek model assumes that
the short rate eventually reverts to a constant long-
horizon average and has constant volatility. Thus, the
2See Oldrich Vasicek, “An Equilibrium Characterization of the Term Structure,”
The Journal of Financial Economics, 1977, pp. 177-188.
3 May 1998
speed of mean reversion, the long-horizon average, and
the volatility completely describe the evolution of the
short rate. Under the assumption that riskless arbitrage
is not possible, the model determines parameter values
of the short rate process that are consistent with the real
term structure. The current short rate and the yield on a
long maturity discount bond control the slope and shape
of the term structure. In the Vasicek model, the long
maturity yield is a function of the short rate parameter
values. (See the Appendix for details.) Since the real
short rate plays a prominent role in this analysis, we first
examine its history during the 1987-1998 period.
The History of Real Short Rates
The real short rate is defined as the difference between
the nominal short rate and expected instantaneous infla-
tion. We approximate market inflation expectations by a
12-month moving average of CPI changes and use the
3-month general collateral repurchase rate as a measure
of the nominal riskless short rate. Figure 1 shows the
daily history of nominal and real short rates for Jan-
uary 2, 1987-February 27, 1998. Real rates have been
as high as almost 6% and as low as 0%; the historical
average for the period is 2.5%. Although the real short
rate has remained far from its average for extended
periods of time, it has consistently reverted. The histori-
cal half-life of the short rate, a measure of the speed with
which the short rate reverts to its long-horizon average,
is 1.07 years. The historical average short rate volatility
is 156 bp per year though recent volatility has been much
lower. Recently, the real rate has risen sharply to a level
around 4%. This increase was caused by a combination
of a relatively constant nominal rate and falling inflation
expectations. The historically high real short rate has
been accompanied by an inverted real term structure.
Figure 1. Nominal Real and Short Rates,
January 2, 1987-April 30, 1998
%
12
10 Nominal short rate
Real short rate
8
6 Figure 2.
4 4/1/98
2
0 Short rate
-2
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Lehman Brothers
Calibration
We apply the Vasicek term structure model to TIPS
yields. Prior to the introduction of 30-year TIPS, only the
5- and the 10-year maturity ranges were available. The
Vasicek model is calibrated to the prices of two bonds:
the 3 5/8 of 7/15/02 and the 3 3/8 of 1/15/07.3 The
calibration proceeds by fixing the half-life and volatility of
the short rate and searching for the current short rate r0
and the yield on a long maturity bond r∞ such that the
model-implied bond prices match the observed prices.
The current short rate and the long maturity bond to-
gether control the shape of the yield curve. If the short
rate is below the long maturity yield, the curve will be
upward sloping; if the short rate is above the long maturity
yield, the curve will slope downward.
Figure 2 shows the calibration results using closing
prices on 4/1/98, the announcement day, and 4/9/98,
the day after the auction. The half-life of the short rate is
set to 1.07 years. We select the short rate volatility so
that the model-implied yield volatilities of the 5- and
10-year TIPS approximate their observed volatilities.
With the short rate volatility set to 75 bp per year, the
model produces 28 bp 5-year yield volatility and 15 bp
10-year yield volatility. For comparison, the historical
average yield volatilities for the 5-and 10-year TIPS are
28 bp and 24 bp. We use a 75-bp short rate volatility for
all subsequent results. Since the 5- and 10-year yields
were similar on both 4/1/1998 and 4/9/1998, the model
results are similar as well. The implied current short rate
is 4.13% while the long-maturity yield is 3.66%. The
model-implied 30-year yield is 3.73% on both days. The
actual 30-year TIPS yields were 3.75% on 4/1/98 and
3.74% on 4/9/98.
Although the yield curve is currently inverted, the Vasicek
model can generate other yield curve shapes. Figure 3
shows the possibilities. Given the short rate half-life and
volatility and the long-maturity yield values used in the
3 We use the old TIPS 10-year because it is more liquid than the 3 5/8 of
1/15/08.
Calibration of the Vasicek Model
4/9/98
5-year yield 3.86 3.87
10-year yield 3.79 3.79
4.13 4.13
Long-maturity yield 3.66 3.66
Implied 30-year yield 3.73 3.73
Actual 30-year yield 3.75 3.74
4 May 1998
calibration, the yield curve will first flatten and then slope rate could fall if expected inflation increases, if the Fed-
upward if the current short rate falls. Near a short rate of eral Reserve lowers the nominal interest rate, or if a
3.5%, the yield curve is almost flat while a 2.5% short rate combination of the two occurs.
produces an upward-sloping curve. However, if the
current short rate climbs to 4.5%, the yield curve will
become more inverted. A TWO-FACTOR APT APPROACH
Historical Perspective on the Vasicek Model Description of Model
To gain a historical perspective we calibrated the model Our two-factor APT model treats TIPS as having a
to historical 5- and 10-year TIPS yields for the period component of risk within the nominal market and an
8/25/97 to 4/9/98. Each day this procedure produced independent component of risk within the real market.
implied values for the short rate, the long maturity yield, The model expresses the expected returns of all securi-
and the constant maturity 30-year yield. As a check of the ties as a linear function of their risk exposures. In our
model we compared the implied short rate with its histori- framework, the nominal or first factor is a source of risk
cal estimate. Figure 4 displays the two short rates for the for both nominal and real securities while the second
period 8/25/97 to 4/9/98. The two rates are reasonably factor represents an independent source of risk to which
close, with the historical following the model-implied rate. nominal securities are not exposed. A security’s loading
The historical real rate lags the model-implied rate be- on a risk factor represents its exposure to that risk.
cause the expected inflation used to adjust the historical
nominal rate is updated only once a month.
Figure 4. Model-implied and Historical Real
Figure 5 shows the evolution of the model-implied Short Rates, August 25, 1997-April 9, 1998
current short rate and the long maturity yield. During %
4.4
this period, the real short rate increased from 3.65% to Model-implied
over 4.1% while the long maturity yield stayed in the 4.2 Historical
3.45%-3.7% range. The real short rate increased be-
4.0
cause inflation expectations fell and the nominal short
rate stayed steady at around 5.5%. The fact that the 3.8
implied long-maturity yield was relatively constant sup-
3.6
ports our application of the Vasicek model since one of its
assumptions is a constant long maturity yield. If the 3.4
real short rate begins to revert toward its long-horizon
3.2
average and all the other model parameters remain 8/25 9/15 10/3 10/24 11/14 12/8 12/29 1/20 2/9 3/2 3/20 4/9
constant, the real yield curve will steepen. The real short 1997 1998

Figure 3. Possible Yield Curve Shapes for Different Figure 5. Short Rate and Original Maturity Yield
Real Short Rates August 25, 1997-April 9, 1998
% %
4.5 4.5

Short Rate
4.0 Long Maturity Yield
4.2

3.5
3.9
3.0 4.30%
4.13%
3.50% 3.6
2.5
2.50%

2.0 3.3
00.5 5 10 15 20 25 30 8/25 9/15 10/3 10/24 11/14 12/8 12/29 1/20 2/9 3/2 3/20 4/9
Maturity (in years) 1997 1998

Lehman Brothers 5 May 1998

Correlations between yield changes of nominal and real
securities of similar maturities play an essential role in
distributing the total risk of a security between the two risk
factors. A real security’s loading on the first risk factor
increases as the correlation between real and nominal
yields increases. This is because as the correlation
increases, the real security behaves more like its nominal
counterpart and takes on more nominal-like risk charac-
teristics. In the extreme case of perfect correlation, the
TIPS do not represent a distinct asset class and so weight
fully on the first factor. The historical correlations be-
tween the 5-year nominal par rate and the 3 5/8 of
7/15/02 have ranged from 0.1 to 0.8, indicating that the
second factor is necessary for describing the risk expo-
sures of TIPS.
Determining Risk Loadings of Nominal
and Real Securities
For nominal securities, the total price risk is defined as
the implied basis point volatility from the options market
multiplied by duration. Since options on TIPS trade thinly,
we use their historical volatilities. A real security’s loading
on the first factor is the product of its total price risk and
its correlation with nominal rates of the same maturity.
The second factor loading is found by enforcing the
condition that total variance equals the sum of the squares
of the two factor loadings. This condition is a conse-
quence of the independence of the two factors. From the
definitions of the factor loadings, it follows that when the
correlation is zero the security weights fully on the sec-
ond factor, and when the correlation is one it weights fully
on the first factor. The correlation in the 10-year sector
was about 0.65 at of the end of April, 1998. Figure 6
shows the factor loadings on 4/9/98.
Estimation of Model
The linear relationship between expected return and risk
loading on each factor is estimated from the risk/return
structure of nominal 2s, 5s, 10s, and 30s, and 5-year
TIPS and the 10-year TIPS of 1/07. The expected return
of a nominal bond is its yield (par yields are used) plus the
value of convexity. This is an instantaneous expected
return that assumes a mean zero yield change over a
Figure 6. Factor Loadings of Nominal and Real
Securities on 4/9/98
5-yr 10-yr
Bond 2-yr 5-yr 10-yr 30-yr TIPS TIPS 1/07
Factor 1 66 bp 79 78 75 27 25
Factor 2 0 bp 0 0 0 23 20
Lehman Brothers
very short horizon. For the TIPS, an additional constant
must be added to account for the expected return due to
the accrual of principal with inflation. We describe below
how this constant is determined. According to the model,
the expected return of each security is a linear function of
its risk loadings. We regress the expected returns of the
six securities on their factor loadings to find the implied
risk/return plane. In one-factor APT models, the risk/
return relationship is a straight line, representing the
extra return investors expect for taking on each additional
unit of risk. But in the two-factor world, risk can be
assumed in two possible directions, each with its own
price. The result is a plane in risk/return space. Any
security with known risk loadings will have an implied
expected return on the plane.
Because the current inflation rate is unobservable, we
perform the above regression for a range of inflation
values. The inflation rate is held constant across maturi-
ties because all returns are considered to occur over a
very short horizon. The implied inflation rate is the one
that gives the best fit to the data. On 4/9/98 it was 1.3%.
We plot the inflation rate implied by the two-factor APT
model in Figure 7.
Extrapolating the Yield of the 30-year TIPS
To determine a range of feasible risk loadings for the
30-year TIPS prior to when-issued trading, we assumed
that the basis point volatility of the 30-year TIPS would be
70%-90% of the volatility of the 3 3/8 of 1/15/07. This
assumption was based on the relationships between
10- and 30-year volatilities in the nominal market. We
further assumed that the correlation between real and
nominal 30-year rates would be close to the average
Figure 7. Inflation Rate Implied by 2-factor APT Model
August 25, 1997-April 9, 1998
%
2.2
2.0
1.8
1.6
1.4
1.2
1.0
8/25 9/15 10/2 10/23 11/10 12/2 12/19 1/9 1/29 2/18 3/9 3/26 4/9
1997 1998
6 May 1998
correlation between existing reals and nominals. Given
these correlation and volatility ranges, we computed
factor loadings and used the prices of risk from the
regression to calculate a range of possible expected
returns for the 30-year. The yield of the 30-year TIPS was
computed by netting out the implied current inflation rate
and the value of convexity from the model’s expected
return. The range we found was 5-15 bp below the yield
of the 3 3/8 of 1/15/07. Now that 30-year TIPS are actively
trading, we find that the model best fits the real yield curve
when the correlation of the 30-year is set 10% higher than
the 10-year sector correlation and 30-year volatility is set
to 75% of 10-year volatility. Figure 8 plots 30-year TIPS
model yields versus actual yields from 4/1/98 to 4/29/98
using these values. The average absolute error was
1.8 bp. In particular, the actual yield on the announce-
ment date was about 4.5 bp above the model yield.
Effect of Correlation and Volatility on the
Model Real Yield Curve
For higher correlations, TIPS behave more like nominal
securities. As a result the model real yield curve becomes
more like the nominal curve. In an upward sloping nomi-
nal market, this translates into a steeper model real yield
curve. The effect of volatility on the model real curve
depends on the level of correlation. In general, higher
volatility increases the magnitude of the yield spreads
between maturities. At low correlations the curve be-
comes more inverted, but for high correlations the curve
becomes more upward sloping. Figure 9 demonstrates
these effects. To construct these curves, we first esti-
mated the risk/return plane using data on 4/9/98. Holding
this plane fixed, we recomputed factor loadings of the
TIPS using three correlation levels (constant across
Figure 8. Actual and Model 30-year TIPS Yields
April 1-29, 1998
3.80
3.75
3.70
3.65
Actual
3.60 2-factor APT
Vasicek
3.55
4/1 4/3 4/7 4/9 4/14 4/16 4/20 4/22 4/24
Lehman Brothers
maturity) and three volatility levels. The first plot holds
correlations fixed at 0.6 and shows the model real
curve for volatilities of 50%, 90%, and 130% of the
historical volatilities. As volatility increases the
curve becomes more inverted. The next plots shows the
model curve at a correlation level of 0.8. For each
volatility, it is steeper than the corresponding curves in
the first plot, yet as volatility increases, it becomes more
inverted. For a correlation of 1.0, shown in the last plot,
the curve is upward sloping and becomes steeper for
higher volatilities.
Empirical Validation of the Effect of Correlation
on the Model Real Yield Curve
We have shown that as correlations increase, the model
real curve becomes more like the actual nominal yield
curve. More precisely, the spread between the 5-year
TIPS yield and the old 10-year TIPS yield becomes
closer to the nominal 5s-10s par yield spread. The
difference between these two spreads can alternatively
be viewed as the pick-up in inflation premium from the
5- to 10-year sector. The inflation premium at a given
maturity is the yield spread between nominal and real
securities of the same maturity. It is the extra yield
investors require for bearing inflation risk in the nominal
market. The inflation premium has typically increased
from the 5- to the 10-year sector as a result of an upward
sloping nominal yield curve and a downward sloping real
yield curve. On 4/9/98, the inflation premiums were 170
bp in the 5-year sector and 190 bp in the 10-year sector
(using the 3 3/8 of 1/15/07 ), giving a pick-up of 20 bp. The
dynamics of the two-factor APT model imply that the pick-
up in inflation premium from the 5- to 10-year sector
moves inversely to correlations. The historical covariation
of the inflation premium pick-up from the 5- to the 10-year
sector with the nominal/real correlation has exhibited this
behavior. Figure 10 graphs the historical pick-up in
inflation premium together with the nominal/real correla-
tion. We believe the negative covariation indicates that
lower correlations between real and nominal securities
accompany periods of greater uncertainty of expected
inflation. During periods of greater inflation uncertainty,
investors require more compensation for extending dura-
tion in the nominal market or pay more for inflation
protection in the real yield market. The historical relation-
ship between correlations and inflation premiums not
only offers empirical validation of the APT model but also
suggests that returns of simultaneous curve trades in the
nominal and real markets should be related to the corre-
4/28 lation levels.
7 May 1998
Figure 9. Model Real Yield Curve for Selected Correlations and Volatilities*

a. Correlation = 0.6 vol = 50 b. Correlation = 0.8 c. Correlation = 1

% vol = 90 % %
4.0 4.00 4.5
vol = 130

3.9 4.4
3.95
3.8 4.3

3.7 4.2
3.90
3.6 4.1

3.5 3.85 4.0

0 5 10 15 20 25 30 35 0 5 10 15 20 25 30 35 0 5 10 15 20 25 30 35
Maturity (years) Maturity (years) Maturity (years)

*Volatility is expressed as a percentage of historical basis point volatility except for the 30-year, which is 75% of the 10-year volatility.

approach, the model real short rate has closely followed

Figure 10. Inflation Premium Pick-up from 5s to 10s
versus Nominal Real Correlation an actual short rate proxy defined as the 3-month
Correl. bp general collateral rate net of the 12-month CPI average.
1.0 Correlation 30 We have also observed that the implied long-term
10s Spread-5s Spread (bp) real spot rate has been stable, which is in line with model
0.8 25
assumptions. In the case of the two-factor model, the
implied relationship between nominal/real correlation
0.6 20
and the slopes of the real and nominal term struc-
0.4 15
tures has been empirically observed. As correlation
increases, the slopes become more alike. Also the
0.2 10 current inflation rate implied by the APT model has been
in agreement with actual inflation and the underlying
0.0 5 economic fundamentals.
8/25 9/19 10/16 11/7 12/5 12/31 1/27 2/20 3/17 4/9
1997 1998
The general implication of the Vasicek model is that if the
real short rate falls, perhaps due to Fed easing or
CONCLUSION increasing inflation expectations, the real curve will
steepen. The conclusion of the APT model is that, in the
We use a one-factor Vasicek model to identify intuitive current environment, an increase in correlation between
parameters that affect the term structure of real yields nominal and real yield changes, possibly because of a
and a two-factor APT model to connect the real and decrease in uncertainty of expected inflation, will likely
nominal yield curves. The model 30-year TIPS yields result in a steeper real term structure. A decrease in
since announcement date have closely matched correlation will have the opposite effect. Also, an in-
actual trading history. Back-testing supports the histori- crease in volatility of real yields is likely to result in a more
cal validity of both models. In the case of the one-factor inverted real curve.

Lehman Brothers 8 May 1998

APPENDIX the parameters. At time t the price of a discount bond of
maturity s is:
The Vasicek Model
1
The Vasicek model is one of the earliest of a class of P (t ,s ) = exp  [1 − exp (− a (s − t ) ) ] [r∞ − rt ]
models called equilibrium term structure models. The a
general approach these models take is to find the term 
σ2
structure of bond yields that is consistent with one or − (s − t ) r∞ − [1 − exp(− a (s − t ) ) ]2 
4a 2

more random factors and an absence of riskless arbi-
trage. In the Vasicek model the short rate is the only risk The yield on a long maturity discount bond is a func-
factor. The model’s basic building block is the equation tion of the short rate parameters and the price of
describing the evolution of the short rate: real risk:

∆r = a(b – r) ∆t + σ∆Z, σ 1σ2

where r is the current short rate, ∆ denotes an increment,
b is the long-horizon average of the short rate, a is the
speed of mean reversion, σ is the volatility, and Z is a
random shock. The long-horizon average b is the level
around which the short rate is expected to fluctuate.
One appealing feature of the Vasicek model is that it
gives the prices of discount bonds as a simple function of
r∞ = b + q − ,
a 2 a2
where q denotes the price of real risk. We use the pricing
expression to calibrate the model. Fixing a and σ, we
search for the values of r∞ and r0 that exactly price the
5-year and the old 10-year TIPS. It is well known that the
Vasicek model cannot similarly fit the nominal Treasury
curve. This suggests that the shape of the real yield
curve is simpler than the shape of the nominal curve.

Lehman Brothers 9 May 1998