According to this website, the yields of TIPS of longer maturities are greater than that of TIPS of shorter maturities. It seems counterintuitive since yields of longer-maturity bonds, which are based on expectations of the average of future inflation and interest rates over the holding period of the bond, should be less affected by current economic conditions. On the other hand, the site writes that the shorter-maturity TIPS are less sensitive to current interest and inflation rates. Why is this so?
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$\begingroup$ If A is greater than B, that says nothing about the sensitivity of A nor that of B if you use the conventional meaning of sensitivity which can be defined as the standard deviation. $\endgroup$– H2ONaClCommented Jan 10, 2023 at 1:09
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1 Answer
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{Comparison of TIPS yields}
In order to understand the TIPS yield curve, you need to look at the breakeven inflation curve. Breakeven trades literally pay off based on the gap between realised inflation rates versus the entry breakeven rate. This is the fundamental valuation metric for these bonds; the quoted yield is the residual.
(There is the issue of embedded risk premia. This is complicated by the breakeven being a spread; the premium in the breakeven is the difference between risk premia in the conventional and the inflation-linked. There are factors that could push the risk premium in the breakeven to be positive or negative.)
The implication is that investors project breakeven inflation, and the shape of the indexed yield curve (quoted inflation-linked yields) is forced to price that inflation trajectory. The resulting shape can be very unusual, particularly at short maturities.
On the other hand, the site writes that the shorter-maturity TIPS are less sensitive to current interest and inflation rates. Why is this so?
Short-dated bonds have lower durations. As for the statement about inflation, your phrasing implies an incorrect statement.
- The sensitivity to breakeven inflation depends upon the duration, with longer duration bonds being more sensitive (by definition).
- The sensitivity to realised price changes is equal for all TIPS: a shock to the CPI index moves the value of all bonds by the same percentage amount. (All cash flows are indexed, and if the start point of the index is shocked, all cash flows have the same percentage shift.)
answered Aug 17, 2020 at 14:04
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$\begingroup$ Sorry, I was not clear in my question. I was meaning to compare TIPS of longer maturity to TIPS of shorter maturity $\endgroup$ Commented Aug 17, 2020 at 14:07
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1$\begingroup$ I just deleted the apples-to-oranges part. The second part explains it: what matters is the breakeven inflation curve. It needs to price expected inflation. The quoted yields are the residuals between breakeven and the nominal curve. $\endgroup$ Commented Aug 17, 2020 at 14:14
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$\begingroup$ Liquidity preferences too, yes? That's one of the typical justifications for higher yields for non-indexed bonds... and applies just as well here. $\endgroup$– kurtosisCommented Aug 17, 2020 at 15:34
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$\begingroup$ Term premium? Yes, that means that observed breakevens will depart from expected values. However, this does not effect the economic breakeven. That is why I wrote “fundamental” valuation. Breakevens can be theoretically biased in either direction from expected values. $\endgroup$ Commented Aug 17, 2020 at 17:27