1 TREASURY INFLATION PROTECTED SECURITIES: INFLATION HEDGE OR DEFLATION OPTION Presented at EFA April 11-13, 2002 Ron D’Vari, Ph.D.,CFA Sr. Vice President, Director of Research, State Street Research & Management Adjunct Professor, Graduate School of International Economics and Finance, Brandeis University Lal C. Chugh, Ph.D. Professor, College of Management, University of Massachusetts, Boston

2 MOTIVATION ANATOMY OF NOMINAL INTEREST RATES BREAK EVEN IMPLIED INFLATION RATE (BEIIR) VARIOUS INFLATION INDEXED STRUCTURES NOTION OF DIRECT AND INDIRECT DURATIONS WHY TIPS ARE MARKET COMPLETING EXPANDED PERSPECTIVE AND PORTFOLIO IMPLICATIONS AGENDA

3 PROVIDE EXPANDED PERSPECTIVE ON TIPS EXPLAIN DRIVERS OF THE DIFFERENTIAL BETWEEN NOMINAL AND REAL RATES CLARIFY ECONOMIC ENVIRONMENT SUITABLE FOR HOLDING TIPS SUGGEST SEVERAL PORTFOLIO APPLICATIONS AND IMPLICATIONS OBJECTIVES

4 ANATOMY OF NOMINAL INTEREST RATES EXPECTED REAL RATE EXPECTED INFLATION RISK PREMIA UNEXPECTED REAL RATE PREMIUM UNEXPECTED INFLATION PREMIUM OTHER RISKS’ PREMIA EMBEDDED OPTIONS CONVEXITY BIAS LIQUIDITY, TAXES, CREDIT

5 BREAK EVEN IMPLIED INFLATION RATE MARKET NOMINAL RATE = MARKET REAL RATE + BEIIR MARKET REAL RATE = EXPECTED REAL + UNEXPECTED REAL PREMIUM + REAL BOND LIQUIDITY PREMIUM - REAL CONVEXITY BIAS - REAL BOND DEFLATION OPTION BEIIR = EXPECTED INFLATION + UNEXPECTED INFLATION + REAL BOND DEFLATION OPTION + (REAL-NOMINAL) CONVEXITY BIAS - REAL BOND LIQUIDITY PREMIMUM

6 NUMERICAL EXAMPLE AS OF 9/20/01

7 POSSIBLE INFLATION-LINKED STRUCTURES –Interest Indexed (less inflation protection) –Capital Indexed (more inflation protection) –Zero-coupon Indexed (most inflation protection) –Indexed Annuity MOST DESIRABLE : Capital Indexed –Real Coupon, Actual/Actual, Semi Annual (SA) –Nominal SA Coupon Payments Original Par * (Index Ratio on Coupon Date) * ( Real Coupon)/2 –Current Principal = Indexed to CPI-U NSA At maturity it is Max (100 * CPI-U NSA Index/Ref Index, 100) VARIOUS STRUCTURES

8 Nominal Price is a function of past inflation not future inflation (3-Month Lagged CPI-U Index on Settlement Date) Index Ratio = ( 3-Month Lagged CPI-U Index on Issuance Date) Price/Yield calculation is done in real domain and converted to nominal by the index ratio

9 AFTER AN EARLY START IT HAS COME TO A HALT CORPORATE ISSUANCE  TVA, $300MM, 10-YR  FHLB, $200MM, 10YR  JP Morgan, $200MM, 15YR  Salomon Brother, $400MM, 5YR  Toyota Motor Credit, $100MM, 5YR MIPS (Municipal) PROTECTED FROM INFLATION AND TAXES  Before-tax yields are very low (CPI-U+1%) CORPORATE, AGENCY, AND MUNIES ISSUANCE

10 Revisions to CPI Calculation Methodology: Potential Stripping  Coupon and principal strips of different bonds not combinable  Different bonds different reference index ratios  For tax purposes, strips are treated as OID  No stripping has yet occurred Trading Practices - Straightforward  PSA “Trading Practice Guidelines”  Price and quotation on real basis  Settlement price is adjusted based on settlement index ratio  Forward pricing beyond a month is problematic OTHER RELEVANT ISSUES

11 FLOATING NOMINAL BONDS  NEUTRAL TO INFLATION  NEUTRAL TO GROWTH  CURRENT INFLATION AND GROWH CAN BE REINVESTED AT PREVAILING RATES TIPS  NEUTRAL TO INFLATION  BET ON LOWER GROWTH  INFLATION IS ACCRETED  REINVESTMENT RISK TO REAL RATE NOMINAL FIXED RATE BONDS  BET ON LOWER INFLATION  BET ON LOWER GROWTH  REINVESTMENT RISK TO BOTH REAL AND INFLATION COMPONENTS BEHAVIOR OF FLOATING, TIPS, AND NOMINAL BONDS

12 WHY TIPS ARE MARKET COMPLETING

13 NOTION OF DIRECT Vs. INDIRECT DURATION DIRECT  PARTIAL DURATION  CHANGING OF ONE VARIABLE WHILE HOLDING OTHERS CONSTANT INDIRECT  EMPIRICAL OR TOTAL DURATION  INCORPORATING INTERDEPEDNECE BETWEEN VARIABLES TIPS  DIRECT DURATION TO INFLATION = 0  INDIRECT DURATION TO INFLATION = POSITIVE – INFLATION , REAL RATE   PRICE  DURATION OF OTHER INSTRUMENTS TO INFLATION

14 HEDGING TIPS IN NOMINAL PORTFOLIS

15 DURATION TO NOMINAL RATES MOST PORTFOLIOS ARE CONCERNED WITH NOMINAL INTEREST RATE SENSITIVITIES

16 PORTFOLIO PERFORMANCE IMPLICATIONS ECONOMIC ENVIRONMENT SUITABLE FOR HOLDING TIPS –INFLATION RISK: TIPS PROVIDE A HEDGE –DEFLATION RISK: TIPS PROVIDE A FLOOR ON PRINCIPAL –LOW GROWTH: TIPS APPRECIATE IN PRICE AND PROVIDE INSTANTANEOUS PRICE RETURNS

17 EXPANDED PERSPECTIVE ON TIPS – TIPS ARE NOT ONLY HEDGE FOR INFLATION BUT PROVIDE AN OPTION ON DEFLATION DRIVERS OF THE DIFFERENTIAL BETWEEN NOMINAL AND REAL RATES – INVESTORS INFLATION EXPECTATIONS – EMBEDDED OPTIONS – OTHER RISK PREMIA SUCH AS UNEXPEXTED REAL AND INFLATION ECONOMIC ENVIRONMENT SUITABLE FOR HOLDING TIPS –INFLATION RISK: TIPS PROVIDE A HEDGE –DEFLATION RISK: TIPS PROVIDE A FLOOR ON PRINCIPAL –LOW GROWTH: TIPS APPRECIATE IN PRICE AND PROVIDE INSTANTANEOUS PRICE RETURN SUMMARY