B l o o m b e r g M a r ke t s

FOCUS RISK MANAGEMENT April 2001 123

A factor-model approach to analyze U.S. and U.K. inflation-linked bonds

WHY TIPS LOOK CHEAP

B y E r i c B e r g e r , W a lt e r S t o r t e l d e r , a n d B e n j a m i n W u r z b u r g e r

In January 1997 the U.S. Treasury first with higher (nominal) tax revenues, so that 16, 2001, in table 1 because that was the
issued TIISTreasury inflation-indexed a second argument in favor of TIP debt is pricing date for a new 10-year TII issue by
securities, also known as TIPS: Treasury that from an asset-liability perspective, the Treasury. The issue price was approxi-
inflation-protected securities. Both the its a better match than nominal debt. mately par, and the coupon was set at 3.5
interest payments and the final principal Investors in these sovereign bonds are percent, which can be interpreted as the
payment on these bonds are protected from inflation, so their yields real yield on the bond. The active 10-year
adjusted to the consumer reflect a real return. For such countries as Treasury bond at the time was the 5.75
price index, so the investor in the U.S. and the U.K. that issue both nomi- percent, whose quoted yield to maturity
T i p B ox effect receives a guaranteed nal and inflation-protected bonds, a look at on January 16, 2001, was approximately
Type TII3.5 1/11
<Govt> YA <Go> real rate of return. the difference in the yields of the two 5.25 percent. Using the Fisher equation
for the Inflation- The outstanding volume bonds provides a first approximation of Nominal Yield = Real Yield +
Indexed Yield of these TIPS now exceeds the markets estimate of annualized infla- Expected Inflation,
Analysis function.
$100 billion, but they havent tion over the remaining life of the bonds. we calculate that expected inflation is
The screen shows
the ticker for been well received by the For example, in the U.S., using this 5.25 percent minus 3.5 percent equals 1.75
the consumer market. In 1998 Federal approach, the market-implied inflation over percent.
price index that Reserve chairman Alan the next 10 years, as of January 16, 2001, The method used for drawing conclu-
the security is
Greenspan marveled at how was 1.75 percent, stated on an annualized sions from table 1 is quite crude. To begin
linked to.
cheap TIPS were selling. basis. The details of this calculation are with, were quoting pretax yields and
Type YA <Help>
for more information He noted that their pricing shown in table 1. We chose the date January ignoring after-tax analysis. For the U.S.
on the function. implied that under any
reasonable inflation fore-
cast, 30-year TIPS would
outperform the correspon-
ding unindexed Treasury over a 30-year
horizon (figures 1 and 2).
The Treasurys stated primary motiva-
tion for issuing TIPS was to lower the debt
service cost of U.S. federal borrowing. How
would this be achieved? Investors in nom-
inal bonds receive an incremental yield to
compensate for their exposure to inflation
risk. That cost is included in the coupon on
nominal bonds and is part of the interest
paid by the government on its debt. Since
TIPS investors are not exposed to inflation
risk, the coupon on a TIP bond would be
lower by that amount.
One might challenge this argument by
noting that the risk has simply been trans-
ferred from the investor to the govern-
ment, and should inflation ensue, the FIGURE 1
Step 1 Type TII <Govt> <Go> to list outstanding inflation-indexed bonds issued
government will have to pay out higher
by the U.S. Treasury.
amounts on TIP debt than it would have to
S t e p 2 Type TII3.5 1/11 <Govt> DES <Go> for a description of the inflation-indexed
pay on nominal debt. That is true, but bond issued in January 2001.
inflation should be positively correlated
 B lo o m b e r g M a r k e t s
124 April 2001
FIGURE 2
Step 1 Type ILB <Go> for the Inflation-Linked Bonds: Issue Detail function. ILB
provides links to countries that have issued securities linked to the rate
of inflation.
S t e p 2 For example, type 29 <Go> to list U.K. inflation-linked bonds. The issuers
can be governments, corporations, or municipalities.
this may be acceptable, but for the U.K.
such an assumption is trickier. For a fuller
discussion of the U.K. issues, see Deriving
Estimates of Inflation Expectations from the
Prices of UK Government Bonds, by Mark
Deacon and Andrew Derry, Bank of England,
1994. Additionally, the previous equation
leaves out any inflation risk premium and
liquidity premium. Finally, because of the
yield curves current flatness, this article
neglects the cash flow backloading on the
indexed relative to the nominal.
A second approach to predicting long-
term inflation is based in macroeconomic
TABLE 1
MARKET-IMPLIED INFLATION
Crude approximation of market-implied 10-year average inflation
derived by comparing nominal and real (inflation-protected) yields*
Pricing date
Nominal bond
Inflation-protected bond
Nominal yield
Real yield
Implied 10-year inflation (annualized)
*Excludes any inflation risk premium, liquidity premium, and possible tax factors. **Approximate figure. Source: Bloomberg
FOCUS RISK MANAGEMENT
theory. The assumption is that todays yield
spreads between government bonds with
long (three years and more) and short (one
year and less) maturities contain guiding
information for future inflation rates. Most
research in this area uses a linear model
for the relationship, but recent work
by Greg Tkacz of the Bank of Canada
Non-Parametric and Neural Network Mod-
els of Inflation Changes, 2000, Greg Tkacz,
Bank of Canada, working paper 2000-7,
URL www.bankofcanada.ca/en/wp(y).htm
finds strong nonlinearity in the U.S. data,
so we also use a nonlinear approach with
United States United Kingdom
1/16/01
T 5.75 8/10 UKT 5.75 12/09
TII 3.5 1/11 UKT 2.5 8/11
5.25%
3.50%
1.75%
neural nets. (See sidebar.)
With a prediction for long-term
inflation provided by our nominal yield-
curve-spread-based approach, we can try
to answer the question about whether
TIIS (U.S. TIPS) and inflation-linked gilts
(U.K. ILGs) are rich or cheap relative to
nominal Treasury bonds in their respective
countries. In answering the question,
we add an extra level of sophistication to
the earlier, crude approximation, using es-
timates for the inflation risk premium and
the liquidity risk premium. Before getting
into the details about inflation risk premi-
um, however, lets review the general sub-
ject of risk-factor models and premiums
associated with different risk factors.
Later in this article, we use the arbi-
trage-pricing-theory (APT) model to derive
our estimate of the inflation risk premium.
To set the stage for that discussion, its
worthwhile to first review the more familiar
capital-asset-pricing model (CAPM); the
CAPM can be regardedat least as far as
its conclusionsas a special, single-factor
case of the APT. The CAPM is generally
credited to William Sharpe and John
Lintner; for his contribution, Sharpe shared
the Nobel prize in 1990. (See William
Sharpe, Capital Asset Prices: A Theory of
Market Equilibrium Under Conditions of
Risk, Journal of Finance, 1964.)
Since this section is intended as a lead-
in to our APT discussion, our notation will
follow the notation thats common in APT
analysis. The expression excess return will
mean the return in excess of the risk-free
rate.
ri,t : The realized ex post excess
return on asset i at time t.
RM,t : The realized excess return on
the market at time t.
RM or E [RM,t ]: The expected excess
return on the market. This is also known
as the equity risk premium or the market
price of risk.
1/15/01
xt or RM,t RM : The unanticipated
return on the market at t. By this defini-
tion, its expected value is zero.
4.91%
The key CAPM assumption is that the
2.17%
realized excess return ri,t is a linear function
2.75%**
of xt . The intercept in this equation is de-
noted as i , and the slope in this equation
 B l o o m b e r g M a r ke t s
April 2001 125

as i . The CAPM assumption can therefore
be written algebraically as follows:
ri,t = i + i xt + i,t (1)
(the key CAPM assumption)
Here i,t is the idiosyncratic residual
error, with zero mean. Since both x and 
have zero expectations, i is the expected
value of ri,t , that is, the expected excess
return on the asset. i is the risk expo-
surethe sensitivity of the return ri,t to
the realization of the risk factor x.
This key assumption, in conjunction
with the assumption of market efficiency,
can be shown to imply:
i = i E [RM ] (2)
(the key CAPM result)
Equation (2) says the expected excess
return on i is the product of the assets ex-
posure to the market (i ) times the market
price of risk (E [RM ]). In the APT model, by
convention, the market price of risk is de-
noted by . Equation (2) can therefore be
rewritten as follows:
i = i  (3)
(the key CAPM result, written
in APT notation)
Equations (1) and (3) encapsulate
the CAPM model in a format thats very
compatible with the APT.
Notwithstanding the elegance of the
CAPM, there exist many financial instru-
ments whose total returns are not appro-
priately described as a function of the
aggregate market return. Consider, for
example, a nominal Treasury bond. Over
a short periodso that the capital gains
component dominates the interest
accrualthe total return can be better
described as a linear function of the

Pricing an Inflation Contract

Do investment professionals properly consider inflation risk in their
decisions? Charles, the head of a research department, wondered
whether the fund managers at his firm were thinking clearly on
this subject. He devised the following quiz to test their mettle.
CHARLES Good morning. I was listening to the radio this
morning, and I caught the latest announcement from
a forecasting company with an excellent and unbiased
record of forecasting future inflation. Its latest forecast
is for an inflation rate of 3 percent for the coming year.
Now suppose I offered you a cash-settle forward
contract with the following terms: for every percentage
point by which the coming years inflation ends up exceeding
this forecast value, the payoff to the long is $100. For every
percentage point by which the realized inflation rate falls
short of the forecast value of 3 percent, the long must pay
$100. So, for example, if inflation comes in at 5 percent,
the long position receives $200.
Would you go long this contract? And why or why not?
Heres how Charless colleagues analyzed the situation.
SAM I wouldnt go long this contract. The proper way to
analyze investments in the presence of inflation is to think
in terms of real buying power. Instead of dollars, lets state
payouts in terms of one of my favorite real assets: a slice
of pizza, which now costs $1.
If inflation comes in at 4 percent, pizza will then cost
$1.04 a slice, and Id earn $100 on the contract, which would
translate into a gain of about 96 slices of pizza. Similarly,
if inflation comes in at about 2 percent, pizza will cost $1.02
a slice, and Id lose $100 on the contract, which translates
into a real loss of about 98 slices of pizza.
Assuming those are the only two possible outcomes
and that they are equally likely, then in pizza-slice units, Ive
a 50 percent chance to win 96 slices and a 50 percent chance
to lose 98 slices. That looks like a bad deal to me. I decline.
JAN Unlike Sam, I generally focus on my net worth, not my
stomach. Also, Im much more conservative than Sam, in the
sense that if two strategies have equally expected outcomes, Id
prefer the one with less risk. Id go long the contract. Heres why.
Like Sam, I use a binomial approximation: namely, that theres
a 50 percent probability of inflations coming in at 4 percent
and a 50 percent probability of its coming in at 2 percent.
Now the scenario in which inflation comes in higher than
expected is likely to be bad for my investment portfolioand
not only the bond portion: Its widely recognized that increases
in inflation tend to be associated with declines in stock prices.
If I go long this contract and view it as a part of my
overall portfolio, my expected nominal return hasnt changed
because the contract has a zero expected payoffbut the
variance in my possible returns has declined. In mean-
variance portfolio theory terms, Im at a better point than
Id be without the investment, since my mean hasnt changed
and my portfolios return variance has come down. I would
add it to my position.
CHARLES Sam is wise to think in real terms, and Jan makes
two excellent points: to think of the contract in conjunction
with the other investments and to take her dislike for risk
into account. Actually, the fair price to go long this contract,
according to the accompanying article, would be $27, reflect-
ing the equity markets price of inflation risk and the exposure
represented in this contract.
By the way, this contract isnt completely hypothetical.
The U.S. Treasurys TIPS provide a similar opportunity,
according to the economic analysis in the accompanying article.
E.B., B.W.
 B lo o m b e r g M a r k e t s
126 April 2001
TABLE 2 INFLATION EXPECTATIONS
Comparison of average expected annualized
inflation over 10 years starting January 2001
Method or source
Our nonlinear estimate*
McCulloch**
Philadelphia Federal Reserve Bank
*See sidebar. **Ohio State University.
change in the interest rate over that period.
Edwin Burmeister, Richard Roll, and
Stephen A. Ross, in A Practitioners Guide
to Arbitrage Pricing Theory, in A Practi-
tioners Guide to Factor Models, Research
Foundation of the Institute of Chartered
Financial Analysts, 1994, on pages 8 and
9, note that a decline in interest rates will
be especially beneficial for growth stocks.
The authors also note that luxury product
companies and their stocks will be ad-
versely affected by a rise in inflation, while
companies that hold oil reserves may ben-
efit from increased inflation. These sorts
of considerations suggest that the key
CAPM equation assumption ought to be
generalized so as to recognize that several
risk factorssuch as the change in nominal
rates and the change in inflationdo af-
fect the realized total return on an asset.
Accordingly, the APT model (see
Stephen A. Ross, The Arbitrage Theory of
Capital Asset Pricing, Journal of Economic
Theory, 1976) begins by generalizing
the key CAPM equation assumption to
allow for several risk factors. The APT as-
sumption can be written algebraically
as follows: K

ri,t = i + i , j xj, t + i,t (4)
j =1
(the key APT assumption)
where K is the number of risk factors. The
term xj, t refers to the realization of the jth
risk factor at time t. Under this key APT
assumption, and continuing to assume
market efficiency, one can derive the
following key resulta generalization of
the key CAPM result:
K

i = i , j j
j =1
(5)
(the key APT result)
We are now in a position to state
FOCUS RISK MANAGEMENT
how the different
inflation risk expo-
sures of the nominal
and linked bonds
Inflation: 1/01 to should affect their
1/11 (annualized)
expected returns.
2.4%
Specifically,
1.7
E[return on nominal]
2.5
E[return on linked] =
nominal,  (6)
To arrive at
this, we note that linked, equals zero and
we assume that for all other risk factors
the bonds are similar.
We now estimate the right-hand side
of equation (6).
We estimated  to be minus 0.27.
To estimate  we used 20 years of cross-
sectional monthly returns on U.S. stocks
(those stocks that were in the Standard &
Poors 500 Index at the end of 1998) and
regressed them versus the unanticipated
change in inflation, x, and the unantici-
pated change in the real rate, xr .
During our estimation we found that
the value of  is insensitive to maturity.
This is purely empirical; we didnt come up
with a theoretical motivation and arent
aware of literature on this specific topic.
A related working paper by Silverio Foresi,
Alessandro Penati, and George Pennacchi,
Estimating the Cost of U.S. Indexed Bonds,
Federal Reserve Bank of Cleveland, 1997,
estimates the same quantity by different
means and assumesimplicitlymaturity
independence. These authors arrive at an
estimate of minus 0.23.
As for nominal, , it can be shown that
its equal to minus the modified duration
of the nominal bond. Because of the insen-
sitivity of  to maturity, the inflation
exposure clearly declines during the life of
the nominal bond and its acceptable to
take an average duration over the remain-
ing life. In our casethe 10-year nominal
Treasurythe average duration for the
nominal is 4.0, leading to an inflation risk
premium of minus 0.27 times minus 4.0
equals approximately 1.1 percent.
The value of 1.1 percent is very close to
what John Y. Campbell and Robert J.
Shiller report for the theoretical value of
the inflation risk premium. They provide
various estimates, and their two preferred
estimates are 0.9 percent and 1.5 percent.
The Campbell/Shiller technique is very
different from ours. In particular, it doesnt
refer to the APT and it doesnt make use
of cross-sectional data on equity returns.
(See A Scorecard for Indexed Government
Debt, National Bureau of Economic
Research Macroeconomics Annual, 1996.)
The main ingredient in a comparison of
nominal and inflation-protected bonds will
be the modeling of the inflation process,
since both securities are similarly affected
by changes in the real rate. To predict in-
flation rates for short horizons (less than
one year), we use a nonlinear vector auto-
regressive (VAR) model. This means
without getting too much into time series
analysisthat historical time series of in-
flation and interest rates are used for tuning
a model that generates future interest and
inflation rates. In our experience, this ap-
proach gives satisfactory results for short-
horizon predictions up to about one year.
For longer predictions, we use a com-
bination of the VAR model and the ap-
proach suggested by Tkacz using neural
nets. Lets look at this approach more
closely. Let ym(t) denote the m-month spot
nominal yield on a government bond as of
time t. Given two termsm and n months,
respectivelythe yield spread at time t
for these is the difference
ym(t) yn(t), (m>n)
This spread helps predict the inflation
change from t+n till t+m. As an example,
lets take todays 1-year and 10-year
yields; that is, m equals 120 and n equals
12. If we substitute this difference into
our model, which is estimated by using
half a century of historical data, we get a
prediction for the change in inflation from
1 to 10 years from now.
From the VAR approach, we estimated
the inflation from today 1 year ahead, so the
sum of these two numbers will give the
expected inflation for the next 10 years. This
is the number we use for our 10-year infla-
tion prediction. We repeat this exercise for
nominal government securities with differ-
ent maturitiesinterpolating when need-
edto derive inflation expectations that
match the whole range of TIPS maturities.
 B l o o m b e r g M a r ke t s
April 2001 127

A Neural Nets Primer

Neural nets are used for connecting in a nonlinear way
(1) inputs that are independent or explanatory variables
with (2) outputs that are dependent variables. This is
done by a very general and flexible regression tool,
and the technique is used when you dont have an exact
idea what the mathematical relationship will look like.
The analysis in the accompanying article includes an
econometric estimation of long-term future inflation. One
of the key inputs to this estimation is the spread between
long- and short-term yields. Unless youre a professional
macroeconomist, you may not know that the relationship
of this spread to future inflation rates is highly asymmetrical.
If the yield curve is positively sloped, the relationship is
weak; if the yield curve is inverted, then empirical analysis
suggests that inflation rates will decline (see the work
of Tkacz referenced in the article). This asymmetry can
be captured in a nonlinear model. A powerful tool for
developing such a model is neural nets.
Suppose we have NINP explanatory variables and add
one additional, artificial inputan input thats always one
and is used for incorporating an intercept as in standard
linear regression. In addition, we have NOUT dependent
time series. These time series are fed into the neural net
in order to calibrate our modelthat is, to estimate the
parameters of the neural net by a nonlinear regression
procedure. A schematic plot of a neural net with one
interior layer is shown in chart A.
We denote the parameter connecting the ith input with
the jth interior node by i, j and the parameter connecting
the jth interior node with the kth output by j, k . Besides,
the function connecting the input layer with the jth interior
node is denoted by fj (.) and the function connecting the
interior layer with the kth output by gk(.). These functions
and their arguments are given by:
INT(j) = fj (INP(0),...,INP(NINP),  0, j , ..., NINP, j ),
OUTP(k) = gk(INT(0),...,INT(NINT), 0, k , ..., NINT, k ).
The parameters i, j and j, k come from the nonlinear
regression procedure. A popular choice for both fj and gk is
the logit function. For fj this leads to:
INT(j) = fj (.) = 1 .
(  i, j . INP(i))

1 + exp NINP
i=0

variables, which depend on the NINP inputs. For both the This expression is substituted into the same type of
independent and dependent variables, we have historical logit functiongk(.)which makes it a quite sophisticated
and nested construction.
CHART A
The flexibility of such a neural
net is due to the freedom of choice
with respect to (1) the number
Inp(0) Int(0)
of interior nodes, (2) the number
of interior layers, and (3) the
Inp(1) Int(1) Outp(1) functions connecting the layers.
Of course, we keep a serious eye
on the number of parameters to
Inp(2) Int(2) Outp(2) avoid overparametrization. More
details on neural nets can be found
in a number of places, including
Artificial Neural Networks,
Inp(NINP) Int(NINT) Outp(NOUT) by R. J. Schalkoff, McGraw-Hill
Cos., 1997, and Neural Networks
Inputs Interior nodes Outputs
in Finance and Investing, eds.
Schematic plot of a neural net with one interior layer, NINP inputs (the zeroth input is always one),
NINT interior nodes (the zeroth interior node always contains one), and NOUT outputs. The weights R. R. Trippi and E. Turban, Probus
or parameters of the neural net correspond uniquely to the lines connecting the layers. Publishing Co., 1993.
W.S.

We used this method for a 10-year hori-
zon. Table 2 shows our result (first line) and
compares it with inflation expectations
from other sources. It shows that our result
is close to the survey result from the
Philadelphia Fed. In the U.K. our economet-
ric forecast is quite close to both the con-
sensus forecast and the government target.
The method J. Huston McCulloch is
using is based on the break-even inflation
implied by the market prices of TIPS, in
which he doesnt incorporate liquidity and
inflation risk premium.
For those investors who are concerned
about liquidity, the nominals enjoy an
 B lo o m b e r g M a r k e t s
128 April 2001
advantage relative to the indexed bonds.
Well assume that the liquidity component
of the nominal versus indexed Treasuries
can be proxied via the liquidity component
on nominal Treasuries versus Aaas.
For the estimation of the liquidity com-
ponent of the Aaa versus the Treasury, we
shall proceed by regarding this spread as
consisting of three components: a liquidity
term, a tax term, and a default/credit
term. We estimate values for the tax
term and the credit term, and we then
interpret the residual componentthe
actual spread less the tax term and the
credit termas the value of liquidity.
The tax term: In the U.S., federal interest
payments are exempt from state and local
taxes. In the U.S., state and local income tax
rates tend to range from 5 to 10 percent;
inasmuch as the effective tax rate tends to
run below the statutory tax rate, we shall
base our calculation on 5 percent. Since
the interest rate is currently running about
6 percent, the exemption is worth about
5 percent times 6 percent equals 0.3 per-
cent, or 30 basis points, relative to the Aaas.
The default term: The annualized
default rate on intermediate-term Aaas
is about 0.1 percent, or 10 basis points. To
translate this default rate into a credit
spread, we should divide by a factor of
twoin order to reflect a recovery rate of
about 50 percent on defaulted bondsand
multiply by a factor of about two in order
to capture risk aversion. This suggests that
the default/credit term contributes about
0.1 percent to the Aaa-versus-Treasury
spread. In total, the tax term and the
default term thus contribute about 0.4
percent to the Aaa-versus-Treasury spread.
TABLE 3 COMPONENTS OF FAIR NOMINAL YIELD
The quantities in equation (7) for the U.S. and the U.K.,
taking a 10-year horizon
Quantity
Real yield (10-year inflation-adjusted govt. bond)
Expected inflation
Inflation premium**
Liquidity premium
Fair nominal yield (10-year government bond)
Actual nominal yield (10-year government bond)
*Refer to table 2. **GB10, = 4.04 and 3.70 for the U.S. and U.K., respectively. Thus, GB10, = 1.1 for the U.S., and 1.0 for the U.K.
FOCUS RISK MANAGEMENT
The value of liquidity: The Aaa-versus-
Treasury spread is currently about 1 per-
cent. Subtracting 0.4 percent for taxes
and defaults, we estimate that the liquid-
ity is worth about 0.6 percent for an
investor who is concerned about liquidity.
Now we have estimates for future in-
flation, the premium for inflation risk, and
the premium for liquidity. These quantities
were derived in order to deal with the sub-
sequent model for the fair nominal yield:
[Fair Nominal Yield] = [Real Yield] +
[Expected Inflation] + [Inflation Premium]
[Liquidity Premium] (7)
where the nominal bond and the indexed
bond have the same maturity.
In studying both the U.S. and U.K. markets,
we came up with the numbers in table 3 for
each term of the fair nominal yield definition.
Let us first consider a U.S. investor who
isnt concerned about liquiditysay, a
buy-and-hold pension fund or an individual
who is saving for retirement. On the 10-year
TIPS, this person will get a real annual guar-
anteed return of 3.5 percent. A crude ap-
proximation would say the nominal Treasury
provides an expected real return of 2.9 per-
cent (from a yield to maturity of 5.3 percent
minus expected inflation of 2.4 percent), but
on a risk-adjusted basis (that is, subtracting
the inflation premium of 1.1 percent) pro-
vides a real return of 1.8 percent. Under this
analysis, the 10-year TIPS is quite cheap rel-
ative to the nominal bonda real return of
3.5 percent versus a risk-adjusted expected
real return of 1.8 percent.
A fairer comparison would include
the liquidity penalty on TIPS. With this ad-
justment, we subtract 0.6 percent from the
TIPS real return to get 2.9 percent versus
United States United Kingdom
3.5%
2.4*
1.1
0.6
6.4
5.3
the risk-adjusted expected real return of 1.8
percent on the nominal bond. The U.S. num-
bers suggest that U.S. investors havent yet
realized how attractive TIPS are, and TIPS
therefore trade cheap relative to nominals.
For a U.K. investor who isnt concerned
about liquidity, TIPS offer 2.2 percent ver-
sus 1.4 percent risk-adjusted real return
on the nominal. TIPS are cheap relative to
nominal bonds.
For a U.K. investor who is concerned
about liquidity, TIPS offer a risk-adjusted 1.3
percent versus 1.4 percent on nominals.
Nominals are slightly cheaper. This closeness
in contrast to the U.S. case suggests that
the U.K. is more sophisticated and more
mature than the U.S. regarding inflation-
indexed bonds, which isnt surprising given
that the U.S. has only relatively recently
introduced TIPS.
For a U.K. taxable-TIPS investor theres an
after-tax advantage, since the capital gain on
the principal due to inflation is exempt from
tax. This leads to an advantage of the tax rate
(we took 25 percent) times the inflation of
2.5 percent, which results in 0.6 percent. That
number, together with the pretax ILG disad-
vantage of 0.1 percent, generates an advan-
tage of the ILG of 0.5 percent after taxes.
Our analysis finds that a U.S. investor
should prefer U.S. TIPS to U.S. nominals. In
the U.K., whereunlike in the U.S.the
linked bonds are tax advantaged relative to
2.2% nominal bonds, a taxable investor should
2.5 prefer U.K. TIPS to U.K. nominals.
1.0
ERIC BERGER, Ph.D.; WALTER STORTELDER, Ph.D.;
0.9
J AS O N S C H N E I D E R
and BENJAMIN WURZBURGER, Ph.D., develop
4.8 financial models for Bloomberg in Tel Aviv.
eberger@bloomberg.net
4.9
wstortelder@bloomberg.net
bwurzburger@bloomberg.net