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Understanding Inflation-Indexed Bond Markets

Like corporate bonds,municipal bonds come with a variety of ratings to reflect the fact that some state and local governments are financially stronger than others.Municipal bonds, which have maturities ranging from less than 1 year to 40 years, are also known as tax-exempt, or tax-free, bonds. Investing in individual bonds An investor may purchase individual bonds for a number of reasons. First, the investor may have great confidence in the ability of the bond issuer to make all interest payments as promised and to repay the principal in full upon maturity | JOHN Y. CAMPBELL Harvard University ROBERT J. SHILLER Yale University LUIS M. VICEIRA Harvard University Understanding Inflation-Indexed Bond Markets ABSTRACT This paper explores the history of inflation-indexed bond markets in the United States and the United Kingdom. It documents a massive decline in long-term real interest rates from the 1990s until 2008 followed by a sudden spike during the financial crisis of 2008. Breakeven inflation rates calculated from inflation-indexed and nominal government bond yields were stable from 2003 until the fall of 2008 when they showed dramatic declines. The paper asks to what extent short-term real interest rates bond risks and liquidity explain the trends before 2008 and the unusual developments that followed. Low yields and high short-term volatility of returns do not invalidate the basic case for inflation-indexed bonds which is that they provide a safe asset for long-term investors. Governments should expect inflation-indexed bonds to be a relatively cheap form of debt financing in the future even though they have offered high returns over the past decade. In recent years government-issued inflation-indexed bonds have become available in a number of countries and have provided a fundamentally new instrument for use in retirement saving. Because expected inflation varies over time conventional nonindexed nominal Treasury bonds are not safe in real terms and because short-term real interest rates vary over time Treasury bills are not safe assets for long-term investors. Inflation-indexed bonds fill this gap by offering a truly riskless long-term investment Campbell and Shiller 1997 Campbell and Viceira 2001 2002 Brennan and Xia 2002 Campbell Chan and Viceira 2003 Wachter 2003 . 79 80 Brookings Papers on Economic Activity Spring 2009 The U.K. government first issued inflation-indexed bonds in the early 1980s and the U.S. government followed suit by introducing Treasury inflation-protected securities TIPS in 1997. .