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Do Inflation-Linked Bonds Still Diversify?

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  • Marie Briere
  • Ombretta Signori

Abstract

The diversifying power of inflation-linked (IL) bonds relative to traditional asset classes has changed significantly. In this paper, we study the dynamics of conditional volatilities and correlations for three asset classes, IL bonds, nominal bonds and equities, in the United States and Europe. Using a DCC-MVGARCH for the period 1997–2007, we highlight the change that took place in 2003. Although IL bonds once had definite diversification power, they are now highly correlated with nominal bonds and have reached similar volatility levels. As a result, the two asset classes are practically substitutable. This seems to be due to more stable inflation expectations and to a more liquid IL bond market. Although diversification was a valuable reason for introducing IL bonds before 2003, this is no longer the case. Dynamic portfolio optimization using our estimates of conditional correlations and volatilities clearly demonstrates that the optimal weight of IL bonds in a portfolio decreased sharply in 2003 in favor of nominal bonds and equities.

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Bibliographic Info

Paper provided by ULB -- Universite Libre de Bruxelles in its series Working Papers CEB with number 07-029.RS.

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Length: 27 p.
Date of creation: 2007
Date of revision:
Publication status: Published by:
Handle: RePEc:sol:wpaper:07-029

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Keywords: inflation-linked bonds; optimal allocation; portfolio choice; conditional volatility; conditional correlation.;

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Cited by:
  1. Cartea, Álvaro & Saúl, Jonatan & Toro, Juan, 2012. "Optimal portfolio choice in real terms: Measuring the benefits of TIPS," Journal of Empirical Finance, Elsevier, vol. 19(5), pages 721-740.
  2. Szafarz, Ariane & Brière, Marie, 2011. "Investment in Microfinance Equity : Risk, Return, and Diversification Benefits," Economics Papers from University Paris Dauphine 123456789/7858, Paris Dauphine University.
  3. John Y. Campbell & Robert J. Shiller & Luis M. Viceira, 2009. "Understanding Inflation-Indexed Bond Markets," Cowles Foundation Discussion Papers 1696, Cowles Foundation for Research in Economics, Yale University.
  4. Brière, Marie & Signori, Ombretta, 2011. "Inflation-hedging Portfolios in Different Regimes," Economics Papers from University Paris Dauphine 123456789/7744, Paris Dauphine University.
  5. Signori, Ombretta & Brière, Marie, 2012. "Inflation-Hedging Portfolios : Economic Regimes Matter," Economics Papers from University Paris Dauphine 123456789/9296, Paris Dauphine University.
  6. Brière, Marie & Signori, Ombretta, 2013. "Hedging inflation risk in a developing economy: The case of Brazil," Research in International Business and Finance, Elsevier, vol. 27(1), pages 209-222.
  7. Marie Briere & Ombretta Signori, 2009. "Inflation-hedging portfolios in Different Regimes," Working Papers CEB 09-047.RS, ULB -- Universite Libre de Bruxelles.
  8. Geert Bekaert & Xiaozheng Wang, 2010. "Inflation risk and the inflation risk premium," Economic Policy, CEPR & CES & MSH, vol. 25, pages 755-806, October.
  9. Aglietta, Michel & Brière, Marie & Rigot, Sandra & Signori, Ombretta, 2012. "Rehabilitating the role of active management for pension funds," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2565-2574.

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