In January 1997 the U.S. Treasury began issuing 10-year inflation-protected bonds with principal and interest payments linked to the consumer price index of all urban consumers. We refer to these as indexed or inflation-linked bonds. In this paper we examine whether and how the availability of indexed bonds might affect investors’ asset allocation decisions. We also study whether the availability of indexed bonds enables investors to construct superior mean variance efficient portfolios.
The latter question is important. A change in an investor’s asset allocation, without an accompanying increase in the risk-return trade-off, may not improve the investor’s welfare. However, an improvement in the expected return for a given level of risk would certainly be attractive to investors.
Indexed bonds have long been a topic of interest to the investment community and government policymakers (see Campbell and Shiller, 1996). For example, advocates of indexed bonds have argued the benefits of such bonds to retirees and other investors who are vulnerable to inflation risk. Other benefits, like lowering financing costs to the Treasury, have also been suggested. Somewhat surprisingly, there has been limited work on the impact of the availability of indexed bonds on investors’ asset allocation decision. Should investors hold a different mix of stocks and bonds in the presence of indexed bonds than otherwise? How does this change the risk-return trade-off facing investors? We offer guidance on this important question.
To examine the effect of indexed bonds on asset allocation, we compare the properties of a portfolio of stocks and indexed bonds with a portfolio of stocks and non-indexed or conventional bonds. Mean, variance, and covariance measures for stock and bond returns are examined. Since investors should, in principle, be concerned with the real purchasing power of their nominal wealth, we emphasize results based on real returns, but present results using nominal returns as well.