Nominal treasury securities and treasury inflation-indexed securities: An examination of their yield spread.
The Treasury department began to offer Treasury securities with returns protected against inflation in January 1997. Inflation was not the main concern for investors back then. Today, the popularity of Treasury Inflation-Indexed Securities (TIIS) is on the rise due to the increased demand for fixed-income securities by investors, the increased supply of TIIS, and the increased possibility of higher fluctuation of price levels. This study analyzes the yields of nominal Treasury securities and TIIS, to determine whether or not the preference for real returns by investors more than compensate for the lack of liquidity of TIIS. To this effect, daily price and yield information (Wall Street Journal) on the five-year conventional Treasury note (maturing July 2002) and the five-year TIIS (maturing July 2002) was gathered from July 1997 to December 2001. The evidence presented in this study indicates that investment in TIIS provides portfolio diversification benefits, and the yield spread between conventional Treasury Notes and TIIS, despite its constant fluctuation, has been lower than the proxy for the annual inflation rate. The first section contains the introduction. The second section describes the methodology used in this study and the results. The last section presents the summary and conclusions.
The Treasury department began offering inflation-indexed securities in January of 1997. At that time, 5-year, 10-year, and 30-year TIIS were issued. In 2000, the Treasury announced that only 10-year and 30-year TIIS would be issued. TIIS are similar to nominal Treasury bonds, except that the value of the principal (and interest payments) is adjusted for inflation (using the consumer price index-urban). However, the yield on TIIS is a real yield that is supposed to measure a real interest rate. According to the Fisher effect, a nominal interest rate is equal to a real interest rate plus the expected rate of inflation (ex ante). If we assume that the yield on a conventional Treasury security measures a nominal interest rate, and the yield on a TIIS security measures a real interest rate, then the yield spread (conventional Treasury yield minus the TIIS yield) should serve as a proxy for the expected inflation rate.
From an investor's point of view, the possibility of investing in securities providing a real interest rate seems valuable: investment value is protected from erosion due to inflation and because of diversification purposes (low correlation between TIIS and nominal securities). From the government's point of view, TIIS are attractive because they can pay public debt with real rates rather than nominal rates that might have a higher measure of inflation.
Several studies have examined the yields of conventional and inflation-indexed Treasury securities. Emmons (2000) and Shelton (2000) have pointed out that TIIS yields, due to marketability and liquidity issues, might not reflect a "true" real interest rate. Shen and Corning (2001), examining the behavior of the 10-year TIIS and the 10-year conventional T-bond for the period 1997-2001, arrived to similar conclusions. Shen and Corning used a ten-year average inflation rate, and in their analysis, the maturity of the conventional Treasury security not always matched the maturity of the inflation-indexed security. Lashgari (2000) examined the monthly yields of inflation-indexed bonds and nominal bonds and found that TIIS yields have "... provided a stable real return which is, at least, statistically equal, and in most cases superior, to the average real rate on nominal government bonds." Lashgari used the 10-year regular T-note and the 10-year TIIS, and analyzed their yields for the period 1998-1999. Sack (2000), while trying to construct a measure of inflation expectations, analyzed the yields of 10-year T-notes and yields on a portfolio of TIIS and Treasury STRIPS. Sack found that his derived measure of inflation compensation (a constant rate of inflation at which the value of the TIIS equals the value of a portfolio of Treasury STRIPS) has become more useful as a predictor of future inflation for the 1997-2000 time period.
This study takes a different approach. First, instruments with a different maturity have been selected. The five-year conventional Treasury note and the five-year TIIS are used because of their similar maturity date, July 2002. None of the previous studies have examined the daily yields of 5-year Treasury notes (conventional and TIIS) for their entire maturity. The analysis of similar securities for their entire maturity should mitigate the importance of the liquidity bias, or at least keep it constant. The first hypothesis to be tested in this study is:
The yield spread, yield on a conventional Treasury note minus the yield on TIIS, is a useful proxy for the rate of inflation.
There is also the possibility that as the 5-year TIIS approaches its final maturity, financial participants might consider it a good investment. Furthermore, the five-year Treasury note is considered one of the safest instruments by investors. Whenever there is a flight to quality, investors choose the five-year note rather than the ten-year note or the thirty-year bond. As the economy deteriorated in the later part of 2000, and after the events of September 11, investors might show a higher preference for TIIS. Brown Brothers Harriman (BBH), in its Global Financial Markets Outlook (2001), describes that "a flight to equity has benefited U.S. Treasuries and penalized investors in credit-sensitive securities". BBH also explains that the corporate spread (investment-grade corporate rate minus U.S. Treasuries rate) widened from about 40 basis points in 1997 to 140 basis points in 2001. Uncertainty and recession realities were possible explanations behind this pattern.
This analysis almost covers the full five-year maturity spectrum of the instruments (1997-2001), with the purpose of capturing long- and short-term proxies for real returns and inflation. The second hypothesis in this study is:
The yield spread exhibits a constant behavior throughout the entire maturity of the 5-year notes.
METHODOLOGY AND RESULTS
Daily yields for the conventional 6 percent Treasury note maturing July 2002 and the 3 5/8 percent TIIS maturing July 2002 were gathered from The Wall Street Journal, from July 25, 1997 to December 31, 2001. Summary statistics about the daily yield spread (conventional yield - TIIS yield) and changes in daily yields are provided in Table 1. Among other things, the yield differential exhibits a wide fluctuation, from negative 0.51 percent to positive 3 percent, and this range seems to differ from the range of changes in expected inflation. The average yield spread for the entire period is 1.86%, which might be a very low estimate of expected inflation during this period of time. The volatility of daily yields as measured by the standard deviation, (either in level form or change form) is much wider for the conventional security than for the inflation-adjusted security. This is an interesting result as some other studies have mentioned that TIIS might exhibit uncertain volatility characteristics that might make them undesirable for portfolio diversification purposes (see Craig (2003)). Finally, the correlation coefficient between daily changes in conventional yields and TIIS yields is only 0.30, which is consistent with the relationship found by other studies (see for example Emmons (2000)). This low correlation coefficient along with low daily volatility, suggest that investors could benefit from TIIS whenever they seek to diversify their portfolios.
Tables 2-6 present the annual summary statistics for the years 1997-2001. The correlation coefficient between daily yield changes of nominal and TIIS securities was at first negative but later on fluctuated between 0.24 (1999) and 0.44 (1998). The means of daily yield changes (conventional and TIIS) are not significantly different from each other, except for 1999, as revealed by a test for the difference in means (t-test with unequal variances). The average (median) yield spread ranged from a low of 1.46 percent (1.66 percent) in 1998 to a high of 2.46 percent (2.47 percent) in 2000. The standard deviation of the yield spread showed the lowest point in 1997 (0.17) and reached a maximum in 2001 (0.84), which might be a reflection of the September 11 events.
Next, an analysis of daily yield changes was done using monthly averages of daily yields, since the inflation rate information is released on a monthly basis by the Bureau of Labor Statistics. Tables 7 and 8 show the monthly average spread, the annual realized rate of inflation (to calculate the inflation rate for July 1997, for example, the July 1997 CPI-U index and the July 1996 CPI-U index, both seasonally adjusted, were used), and the monthly difference between the spread and the inflation rate for 1997-2001.
During the first year of trading, the yield differential was larger than the rate of inflation, by 30 basis points on average, and both measures declined throughout the year. The standard deviation of the inflation rate (0.22) was higher than the one for the yield spread (0.15). Starting in July 1998, the actual inflation rate exceeded the average difference in daily yields (yield spread) between the conventional yield and the TIIS yield, by as much as 80 basis points. Previous studies (see Emmons (2000) and Shelton (2000)) have mentioned that, due to liquidity reasons, the TIIS yield has remained a relatively high proxy for the real interest rate, and evidence of this is presented here. However, the liquidity premium cannot be as high as 80 basis points. Therefore, liquidity alone can not explain the behavior of the yield spread during this time.
In 1999, realized inflation was, again, greater than the difference in yields. However, the differential, spread minus inflation, increased significantly in 1999 (the average differential in 1998 was -0.09 compared to -0.5 in 1999). The differential kept increasing in 2000 (-0.9 compared to -0.5 in 1999), which indicates that the importance of the TIIS yield, as a proxy for the real interest rate, has declined over time, or that other factors (taxes for example) might have played a significant role during this period of time.
In 2001, the inflation rate declined, and the spread also declined, but not as fast (with a lag of at least a month). Furthermore, the differential, spread minus inflation, showed a substantial increase (-1.3 percent in 2001, compared to -0.9 percent in 2000), and the fluctuation in the daily spread also increased significantly (0.86 percent in 2001, compared to 0.23 percent in 2000). This last result seems particularly unusual, as I would expect the opposite to happen as the securities approach their final maturity. Furthermore, the TIIS liquidity and marketability issues, described by previous studies, should diminish in importance as the maturity of the securities become shorter and shorter (and investors, who might be concerned about holding illiquid securities for a long time, find these shorter-maturity securities more attractive). Indeed, the yield spread went from a low of 1.73 percent in January 2001 to a high of 2.49 percent in June 2001. Starting in June, the yield spread showed a remarkable decline. Table 8 shows that the yield spread became negative towards the end of the year, which might be the result of the September 11 events (this negative yield spread continued during the first days of 2002). Finally, for the first time in five years, daily TIIS yields showed a higher variability than daily conventional yields.
The evidence presented here does not support my first hypothesis as the yield spread, the yield on a conventional Treasury note minus the yield on a Treasury inflation-indexed security, has not been a useful proxy for the rate of inflation. For comparison purposes, this study uses an actual rate of inflation. Craig (2003) explains that the expected rate of inflation for this period of time, 1997-2001, was about 2.5 percent. Therefore, regardless of the proxy for inflation used, the yield spread has not been an accurate estimator of the inflation rate. Also, the results do not support my second hypothesis that the yield spread has remained more or less constant throughout the entire maturity of the 5-year notes. The spread changed considerable during 1997-2001. Figure 1 provides evidence of the fluctuation in the yield spread during this period.
For comparison purposes, Figure 2 and Figure 3 show the trend of alternative investments during this period of time. Figure 2 shows the daily yield on the 30-year Treasury bond, and Figure 3 shows the monthly returns of the S&P500 index. The long-term rate hovered around 6 percent throughout the entire period, while the monthly returns on the S&P500 index ranged from a low of -14 percent to a high of 11 percent (average return was 0.09 percent). Table 1 shows the average TIIS yield to be 3.36 percent for 1997-2001. The total return, average TIIS yield plus the average rate of inflation of 2.43 percent, would have made 5-year Treasury inflation-indexed securities a very attractive investment vehicle during this period of time. On the other hand, the Treasury Department may have to reevaluate TIIS, as these new securities might not have lowered the government's borrowing costs.
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SUMMARY AND CONCLUSIONS
This study examines the daily yields of conventional Treasury securities and inflation-indexed Treasury securities almost throughout their entire maturity. The evidence indicates a low correlation between conventional yields and TIIS yields, which suggests that TIIS should provide portfolio diversification benefits. The volatility of daily yields, for the most part, is much higher for conventional securities than for TIIS. The yield spread is much lower than the actual rate of inflation (or expected inflation) and keeps increasing as the securities near maturity (even though the variance seems to remain constant). At the end of 2001, the yield spread starts a sudden decline. In essence, the yield spread has not been a reliable proxy for the rate of inflation and has exhibited a volatile pattern during the years 1997-2001. However, TIIS yields might have provided an attractive investment alternative, compared to bond and stock returns, during this period of time.
The results seem to support the evidence presented by other studies that have documented the inadequate performance of the TIIS yield as a proxy for the real interest rate. Liquidity alone can not explain this performance. Investors should be purchasing TIIS in greater amounts if the federal government is paying a high real interest rate, as reflected by TIIS yields, and if TIIS exhibit desirable portfolio diversification benefits.
Brown Brothers Harriman (2001). Global Financial Markets Outlook. October 2001.
Craig, B. (2003). Why Are TIIS Yields So High? The Case of the Missing Inflation-Risk Premium. Federal Reserve Bank of Cleveland's Economic Commentary, March 15, 2003.
Emmons, W. (2000). The Information Content of Treasury Inflation-Indexed Securities. Federal Reserve Bank of St. Louis' Review, November/December 2000, 25-37.
Lashgari, M. (2000). Information Content of U.S. Treasury Inflation-Indexed Bonds. International Advances in Economic Research 6, 520-31.
Sack, B. (2000). Deriving Inflation Expectations from Nominal and Inflation-Indexed Treasury Yields. The Journal of Fixed Income 10, 6-17.
Shelton, A. (2000). Inflation-Indexed Securities: Description and Market Experience. Public Policy Institute, # 2000- 12, August 2000.
Shen, P. & J. Corning (2001). Can TIPS Help Identify Long-Term Inflation Expectations?. Federal Reserve Bank of Kansas City's Economic Review, Fourth Quarter 2001, 61-87.
Wilcox, D. (1997). The Introduction of Indexed Government Debt in the United States. Journal of Economic Perspectives 12, 219-27.
Woodward, T. (1992). Evidence on the Fisher Effect from U.K. Indexed Bonds. The Review of Economics and Statistics, 315-20.
Jose Mercado-Mendez, Central Missouri State University
Table 1: 5-year Treasury Notes: 1997-2001 Daily Yields Conventional TIIS Yield Conventional Yield Yield Change Average 5.2265% 3.3652% -0.00396% Median 5.59 3.71 0 Standard Deviation 1.1596 0.8374 0.0623 Minimum 1.68 0.91 -0.65 Maximum 6.90 4.12 0.33 # of Observations 1089 1089 1088 Correlation coefficient 0.3011 TIIS Yield Yield Spread Change Average -0.001% 1.8613% Median 0 1.94 Standard Deviation 0.0541 0.6308 Minimum -0.55 -0.509 Maximum 0.5270 3.0040 # of Observations 1088 1088 Correlation coefficient Table 2: 5-year Treasury Notes: 1997 Daily Yields Conventional TIIS Conventional Yield Yield Yield Change Average 5.961% 3.596% -0.003% Median 5.955 3.592 0 Std Deviation 0.159 0.045 0.055 Minimum 5.72 3.498 -0.22 Maximum 6.25 3.723 0.17 # of Observations 108 108 107 Correlation Coefficient -0.0255 Difference in Means -0.5786 TIIS Yield Yield Yield Spread Spread Change Change Average 0.0004% 2.365% -0.003% Median 0 2.341 0 Std Deviation 2.10% 0.170 5.90% Minimum -0.065 2.008 -0.264 Maximum 0.052 2.655 0.182 # of Observations 107 108 107 Correlation Coefficient Difference in Means Table 3: 5-year Treasury Notes: 1998 Daily Yields Conventional TIIS Conventional Yield Yield Yield Change Average 5.232% 3.773% -0.004% Median 5.48 3.78 0 Std Deviation 0.471 0.119 0.059 Minimum 4.14 3.365 -0.25 Maximum 5.80 3.934 0.18 # of Observations 247 247 246 Correlation Coefficient 0.4407 Difference in Means -1.1113 TIIS Yield Yield Yield Spread Spread Change Change Average 0.0003% 1.459% -0.005% Median 0 1.659 -0.006 Std Deviation 0.025 0.387 0.053 Minimum -0.141 0.66 -0.241 Maximum 0.092 2.015 0.153 # of Observations 246 247 246 Correlation Coefficient Difference in Means Table 4: 5-year Treasury Notes: 1999 Daily Yields Conventional TIIS Conventional Yield Yield Yield Change Average 5.534% 3.831% 0.006% Median 5.69 3.856 0.00 Std Deviation 0.413 0.119 0.054 Minimum 4.63 3.58 -0.15 Maximum 6.22 4.063 0.180 # of Observations 241 241 240 Correlation Coefficient 0.2402 Difference in Means 1.3859 * TIIS Yield Yield Yield Spread Spread Change Change Average 0.0008% 1.703% 0.005% Median 0.00 1.805 0.003 Std Deviation 0.022 0.346 0.053 Minimum -0.112 0.866 -0.139 Maximum 0.088 2.221 0.222 # of Observations 240 241 240 Correlation Coefficient Difference in Means * Significant at the 10% level. Table 5: 5-year Treasury Notes: 2000 Daily Yields Conventional TIIS Conventional Yield Yield Yield Change Average 6.279% 3.822% -0.004% Median 6.32 3.81 0 Std Deviation 0.342 0.194 0.049 Minimum 5.17 3.468 -0.14 Maximum 6.9 4.12 0.15 # of Observations 251 251 250 Correlation Coefficient 0.2851 Difference in Means -0.4457 TIIS Yield Yield Yield Spread Spread Change Change Average -0.002% 2.457% -0.002% Median 0 2.472 0 Std Deviation 0.028 0.23 0.049 Minimum -0.111 1.61 -0.135 Maximum 0.105 3.004 0.165 # of Observations 250 251 250 Correlation Coefficient Difference in Means Table 6: 5-year Treasury Notes: 2001 Daily Yields Conventional TIIS Conventional Yield Yield Yield Change Average 3.504% 1.914% -0.015% Median 3.74 1.906 -0.01 Std Deviation 1.029 0.587 0.084 Minimum 1.68 0.91 -0.65 Maximum 5.27 3.66 0.33 # of Observations 243 243 242 Correlation Coefficient 0.3847 Difference in Means -1.1147 TIIS Yield Yield Yield Change Spread Spread Change Average -0.005% 1.59% -0.01% Median -0.006 1.906 -0.005 Std Deviation 0.103 0.840 0.105 Minimum -0.55 -0.509 -0.507 Maximum 0.527 2.885 0.49 # of Observations 242 243 242 Correlation Coefficient Difference in Means Table 7: 5-Year Treasury Notes: Average of Daily Yields (1997-1999) 1997 1998 Spread Inflation Difference Spread January -- -- -- 1.71% February -- -- -- 1.78 March -- -- -- 1.84 April -- -- -- 1.77 May -- -- -- 1.75 June -- -- -- 1.70 July 2.37% 2.17% 0.21 1.65 August 2.57 2.29 0.28 1.50 Sept. 2.47 2.22 0.25 1.13 October 2.34 2.09 0.25 0.80 Nov. 2.27 1.89 0.38 0.98 Dec. 2.16 1.70 0.46 0.87 Average 2.36 2.06 0.31 1.46 Std Dev 0.15 0.22 0.10 0.39 1998 1999 Inflation Difference Spread Inflation January 1.63% 0.08 1.00% 1.73% February 1.44 0.34 1.29 1.67 March 1.38 0.46 1.35 1.79 April 1.44 0.33 1.40 2.28 May 1.69 0.06 1.74 2.09 June 1.62 0.07 2.00 1.97 July 1.68 -0.04 1.69 2.15 August 1.62 -0.12 1.83 2.26 Sept. 1.43 -0.30 1.85 2.57 October 1.49 -0.68 2.07 2.56 Nov. 1.48 -0.50 2.00 2.62 Dec. 1.67 -0.80 2.09 2.67 Average 1.55 -0.09 1.69 2.20 Std Dev 0.11 0.41 0.36 0.36 1999 Difference January -0.73 February -0.38 March -0.44 April -0.88 May -0.35 June 0.03 July -0.45 August -0.43 Sept. -0.71 October -0.49 Nov. -0.62 Dec. -0.59 Average -0.50 Std Dev 0.23 Table 8: 5-Year Treasury Notes: Average of Daily Yields (2000-2001) 2000 Spread Inflation Difference January 2.36% 2.73% -0.37 February 2.54 3.22 -0.68 March 2.64 3.70 -1.06 April 2.66 3.07 -0.42 May 2.81 3.13 -0.32 June 2.48 3.73 -1.26 July 2.43 3.60 -1.18 August 2.46 3.35 -0.89 September 2.35 3.52 -1.17 October 2.41 3.45 -1.04 November 2.41 3.44 -1.04 December 1.88 3.38 -1.50 Average 2.45 3.36 -0.91 Std Dev. 0.23 0.29 0.38 2001 Spread Inflation Difference January 1.73% 3.72% -1.99 February 2.04 3.53 -1.49 March 2.11 2.98 -0.87 April 2.13 3.28 -1.14 May 2.39 3.62 -1.24 June 2.49 3.25 -0.76 July 2.09 2.72 -0.64 August 1.53 2.72 -1.19 September 1.10 2.59 -1.49 October 1.04 2.13 -1.08 November 0.36 1.89 -1.53 December -0.32 1.55 -1.87 Average 1.56 2.83 -1.28 Std Dev. 0.86 0.70 0.42
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|Publication:||Academy of Accounting and Financial Studies Journal|
|Date:||Sep 1, 2004|
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