Labor Income and the Demand for Long-term Bonds
AbstractThe riskless nature in real terms of inflation-linked bonds has led to the conclusion that inflation-linked bonds should constitute a substantial part of the optimal investment portfolio of long-term investors.This conclusion is reached in models where investors do not receive labor income during the investment period.Since such an income stream is often indexed with inflation, labor income in itself constitutes an implicit holding of real bonds.As such, the optimal investment in inflation-linked bonds is substantially reduced.By extending recently developed simulation-based techniques, we are able to determine the optimal portfolio choice among inflation-linked bonds, nominal bonds, and stocks for investors endowed with an indexed stream of income.We find that the fraction invested in inflation-linked bonds is much smaller than reported in the literature, the duration of the optimal nominal bond portfolio is lengthened, and the utility gains of having access to inflation-linked bonds are substantially reduced.We investigate as well the robustness of our results to time-variation in bond risk premia, the riskiness of labor income, and correlation between labor income risk and financial risks.We find that especially accounting for time-variation in bond risk premia and correlation between labor income risk and financial risks is important for both optimal portfolios and the utility gains of having access to inflation-linked bonds.
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Bibliographic InfoPaper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2005-95.
Date of creation: 2005
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inflation linked bonds; optimal lifetime investment; simulation-based portfolio choice;
Find related papers by JEL classification:
- C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
- C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-09-29 (All new papers)
- NEP-CMP-2005-09-29 (Computational Economics)
- NEP-FIN-2005-09-29 (Finance)
- NEP-MAC-2005-09-29 (Macroeconomics)
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