Originally Posted by Rich_in_Tampa
Thanks, Mickeyd. My understanding of TIPs was naive, it appears. I thought of them as inflation protection at the cost of decreased returns compared to similar FI of similar maturity.
While that's not entirely off-base, the benefits of additional diversification and returns that have an upside potential, too, make them more attractive.
I think whether TIPS return more or less than similar maturity bonds depends on the actual rate of inflation versus expected inflation [see pg 5 of the ibbotson paper]. Hence, owning both TIPS and nominal bonds hedges your bets either way. Someone posted some returns for TIPS and nominal bonds in the UK from 1981-2000
over the VD board. It looks like in the 80-90's in the UK, TIPS did not return very much. Perhaps this was due to inflation expectations [from the 70's] being higher than real inflation. Also interesting is that post 2000, things flip-flopped, with TIPS beating nominal bonds.
Since TIPS have been around since about 1997 in the US, and TIAA-CREF has had a TIPS fund since 4/1997 we can do the correlation matrix for a bunch of their accounts [from 4/1997 to 8/2006]:
CREF Inflation linked bond
CREF Bond Market
CREF Equity Index
CREF Money Market
30 day Tbills [courtesy of Ken french]
CREFbond CREFequi CREFinfb CREFmony Tbills CPI
CREFequi -0.136042 1
CREFinfb 0.765623 -0.190142 1
CREFmony 0.169195 0.025680 -0.007228 1
Tbills 0.144833 0.013781 -0.020410 0.981431 1
CPI -0.093373 -0.116935 0.048917 0.001293 0.024667 1
Which is what the Ibbotson paper found [from 1970 - 1998]. TIPS had lower correlation to equites than nominal bonds, albeit slightly.
Anyway, if anyone wants to run efficient frontiers, I've got the monthly returns [nominal and real]. Looks to me like most of the efficient portfolios included both TIPS and nominal bonds.
fyi - here are three more academic papers on diversification with TIPS