TAILIEUCHUNG - An Empirical Decomposition of Risk and Liquidity in Nominal and Inflation- Indexed Government Bonds

Some affluent investors use municipal bond funds as a source of tax-exempt interest income. Because municipal bond funds tend to have lower before-tax interest yields than those on taxable bonds, this investment is usually appropriate only for people in high tax brackets. Finally, investors may use short-term, high-quality bond funds as an alternative to money market this strategy can provide higher returns, it does entail the risk that the investor could lose some principal because of fluctuating bond prices | HARVARD BUSINESS SCHOOL An Empirical Decomposition of Risk and Liquidity in Nominal and Inflation-Indexed Government Bonds Carolin E. Pflueger Luis M. Viceira Working Paper 11-094 Copyright 2011 by Carolin E. Pflueger and Luis M. Viceira Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author. An Empirical Decomposition of Risk and Liquidity in Nominal and Inflation-Indexed Government Bonds Carolin E. Pflueger and Luis M. Viceira1 First draft July 2010 This version March 2011 1Pflueger Harvard Business School Boston MA 02163. Email cpflueger@. Viceira Harvard Business School Boston MA 02163 and NBER. Email lviceira@. We are grateful to seminar participants at the HBS-Harvard Economics Finance Lunch John Campbell Graig Fantuzzi Josh Gottlieb Robin Greenwood and Jeremy Stein for helpful comments and suggestions. We are also grateful to Martin Duffell and Anna Christie from the UK Debt Management Office for their help providing us with UK bond data. This material is based upon work supported by the Harvard Business School Research Funding. Abstract This paper decomposes the excess return predictability in inflation-indexed and nominal government bonds into effects from liquidity market segmentation real interest rate risk and inflation risk. We estimate a large and variable liquidity premium in US Treasury Inflation Protected Securities TIPS from the co-movement of breakeven inflation with liquidity proxies. The liquidity premium is around 70 basis points in normal times but much larger during the early years of TIPS issuance and during the height of the financial crisis in 2008-2009. The liquidity premium explains the high excess returns on TIPS as compared to nominal Treasuries over the period 1999-2009. Liquidity-adjusted breakeven inflation appears stable suggesting stable

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