Harvard Management Co. and Inflation-Protected Bonds – Case Solution

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Harvard Management Co. and Inflation-Protected Bonds Case Answers

1. How do regular (nominal) Treasury bonds work?  How does inflation impact coupons and the principal of T-bonds?  How are Treasury Inflation-Protected Securities different from regular T-bonds?  When do TIPS outperform regular Treasuries?

Treasury bonds are a type of marketable government debt security that pays interest, i.e., coupon payments, semiannually, as well as the principal upon maturity.  Treasury bonds are issued by the U.S. government in maturities of more than ten years.  They are widely considered risk-free and provide investors with income that is only taxed at the federal level.

Inflation can hurt the returns of bondholders expecting nominal coupon payments and principal repayment of T-bonds. This can be seen when comparing the real or inflation-adjusted return of bonds to the nominal return.  A bond yielding 1% nominally may have its returns eroded by inflation if it is 3% over the same period.  This would yield a real return of negative 2% compared to the “on-paper” yield of 1%.

TIPS, or Treasury Inflation-Protected Securities, are treasury bonds that are indexed to inflation, measured by the CPI, and protect investors against inflation. The principal value of TIPS rises with inflation and correspondingly varies as a fixed rate based on the adjusted principal of the bond.  TIPS outperforms regular Treasuries in periods where inflation is rising because the principal is adjusted upward, whereas the nominal Treasury bonds stay fixed.

2. What effect do you think an increase in real interest rates has on the price of TIPS?  What about increases in realized inflation?  How about increases in expected inflation?  An increase in inflation risk?  Are those effects different from a regular T-bond?

I would expect the yields on TIPS to rise (prices to fall) in response to an increase in real interest rates, as rising interest rates tend to lower inflation.  This is because TIPS becomes relatively less attractive in environments in which inflation is not increasing.  Unless the increase in realized inflation is unexpected, this adjustment in price should have been factored in earlier.

As realized inflation increases, the prices of TIPS increase and yields fall as the principal is readjusted, and it pays higher coupons.  Increases in expected inflation would increase the costs of TIPS (falling yields) as investors rush for protection against inflation.  An increase in inflation risk would also drive investors toward Treasury Inflation-Protected Bonds, thus driving up the price.

Regular T-bonds are influenced by inflation and higher interest rates in a different way.  Rising interest rates cause bond yields to rise, thus decreasing the bond’s price.  Inflation, however, produces higher interest rates, which also require a higher discount rate and, therefore, decreases a bond’s price.

3.      TIPS and Risk Management: How can you combine regular (nominal) Treasuries and TIPS with building a hedge portfolio that has exposure to inflation risk but not to real interest risk?

TIPS directly addresses the inflation risk held primarily in a long-term portfolio, contrary to nominal treasuries, in which coupon payments and face value remain fixed in nominal terms but lose value in the real term when compared to inflation rate changes. When expectations lead to increases in inflation rates, TIPS becomes more attractive to investors because future interest payments will be calculated based on current inflation rates using the CPI.

On the contrary, when inflationary expectations decrease (meaning deflation periods), nominal bonds become more attractive as future interest payments become more valuable on a real (or after-inflation) basis. In this setting, TIPS and nominal bonds can be used in the Harvard Management Co.’s portfolio depending on the inflationary expectations to make the fixed-income portfolio less volatile.

Investment managers should compare the yield from a specific TIPS to that of a similar nominal treasury bond. The difference between the yields can be deemed as the…